sp capital iq_2014 strategy outlook

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Time To Move Up the Risk Spectrum: Buy Periphery, Banks & Cyclicals We believe the foundations are set for a multi-year economic expansion in

Europe. As deleveraging ends and banks are finally willing and able to support

their economies, a vigorous investment-driven rebound will develop aided by a

restocking inventory cycle.

External events such as the ECB’s Comprehensive Assessment and the Federal

Reserve’s decision when to ‘taper’ will both prove positive for European equities

but will promote weakness in euro and credit markets, in our view.

We prefer developed market, value strategies and hence are overweight Autos &

Parts, Banks and Construction & Materials, the latter upgraded from

marketweight. Our belief in a strong USD cycle is captured in overweights in both

Healthcare and to a lesser extent Media.

We have downgraded Personal & Household Goods to marketweight and have

underweights on the old economy sectors Basic Resource and Oil & Gas as well

as the defensive trio of Food & Beverages, Telecoms and Utilities.

We have screened our coverage and identified 40 stocks for greatest alpha over

the course of next year (see Appendix).

Our DJ Stoxx 600 target of 375 for end-2014 implies a total return of 21.9%,

premised on 14% EPS growth throughout 2014-15.

2014 European Strategy Outlook

Equity Research

December 10, 2013

End-Year 2014 Index Forecasts

CAC: 4,750 (18.6%)

DAX: 10,700 (19.5%)

FTSE 100: 7,200 (13.6%)

IBEX: 11,200 (24.3%)

MIB: 22,000 (24.6%)

OMX: 1,450 (17.6%)

DJ Stoxx 600: 375 (21.9%)

S&P Capital IQ Equity Research estimates; total return

Table 1: Most & Least Preferred Sectors

Source: S&P Capital IQ Equity Research; 9 December, 2013

Robert Quinn, CFA

Director, Chief European Equity Strategist

+44 20 7176 7843

[email protected]

Cyclicals Defensives / Financials

SXXP Subsector: Recommendation SXXP Subsector: Recommendation

Autos & Parts Overweight Food & Beverages Underweight

Media Overweight Personal & Household Goods Marketweight

Travel & Leisure Overweight Healthcare Overweight

Retail Marketweight Telecommunication Services Underweight

Oil & Gas Underweight Utilities Underweight

Industrial Goods & Services Overweight

Construction Materials Overweight Banks Overweight

Chemicals Marketweight Insurance Overweight

Basic Resources Underweight

Technology Overweight DJ Stoxx 600 -

2

S&P Capital IQ Equity Research

December 10, 2013 2014 European Strategy Outlook

Contents

Executive Summary 3

The Economic Case 4

The Road Is Long, Annual Delta Still Strong 4 Go Forth And Multiply 5 GDP Forecasts Stable And Likely To Be Upgraded 7 Investment Rebound Requires A Couple More Quarters Of Steady Improvements

9 ECB Will Figure Prominently, Has Capacity To Positively Surprise 12 A Chill Eastern Wind … 15 … Insulated By Reform? 17

Banking System Holds The Key 19

Greater Financial Stability 19 Points of Reference: Nordics & US 21 Provisioning Cycle Is Paramount 23 Relative Earnings Momentum Should Drive EU Banks 24

Belated EPS Upgrade Cycle Finally Here 27

10% Earnings Growth in 2014E 27 Biggest Margin Recovery In Cyclical Sectors & Periphery But Beware Traps 29

Themes 31

Financials & Cyclicals 31 Domestic EU > US > EMs 33 Choose Value Over Growth 35 Time To Overweight The Periphery 36

Sectors 39

Current Consensus Forecasts 39 Most Preferred 39 Least Preferred 45

Thoughts On Other Asset Classes 49

Index Targets 51

Appendix - Preferred Stocks 52

Glossary 54

Disclosures/Disclaimers 54

3



Executive Summary

A balance sheet snapshot of European economies reveals the capacity for

future expansion is significant. When viewed through the lens of an income

statement the positive outlook becomes clearer: credit conditions are easing

for both households and non-financial corporates driving a credit impulse

via lower costs of funding ahead of increased lending, retail sales have risen

across most of the big European economies over the past two quarters,

fiscal impulses will be generated across Europe and exports will be

supported by the cyclical improvements in both the US and China. The

largest year-on-year improvements will be visible in the peripheral

economies in our view.

The primary determinants of investment spending are all in place for a 2014

recovery: capacity utilisation levels have rebounded to mid-to-high 70% in a

host of European countries; financing costs have improved markedly and

corporate bank lending standards for corporates eased for the first time

since 2007 in October; and corporate profitability is set to increase.

The Asset Quality Review and subsequent stress test, scheduled for

completion by the end of H1 and Q3 respectively (but not published until

October), will be a defining feature of 2014. The largest banks are likely to

improve their provisioning ahead of the end-2013 cut-off date for analysis;

we are positive on the expected outcomes and we assume 2014 to be the

final year of deleveraging. Loan growth should restart in 2015, in line with

the Nordic and US experiences.

We believe the key event for the EURUSD exchange rate will be when the US

Federal Reserve finally sets a timetable to taper – we believe this could be by

the 18-19 March FOMC meeting.

We forecast 14% EPS growth for the SXXP in both 2014-15. We expect

cyclicals’ earnings to outstrip defensive peers by at least 15ppts over the

next 12 months, allowing the slight overvaluation currently to be quickly

reversed.

We assume that FY/13 EPS stabilises at current levels of EUR21.3. Applying

earnings growth forecasts of 14% for both 2014 and 2015 results in a FY/15

EPS integer of EUR27.7. Given the flow of funds support from other asset

classes and the expected low volatility in economic conditions, we are

sanguine about using a 13.5 times forward multiple, giving us our 375 SXXP

target level for end-2014.

Greatest investment opportunities exist in the peripheral equity markets,

premised on the most spread compression and delta in earnings recovery.

4



The Economic Case

The Road Is Long, Annual Delta Still Strong Returns may have felt difficult to digest due to the high beta markets but equities

have been the best performing asset class over the 2012-13 period, averaging

20% per annum in Europe. The period can also be defined by the increasing year-

on-year (y-o-y) delta of GDP growth. This delta is factored into equity prices in the

prior year and hence our belief is that the 2014 upturn is already fully reflected.

This begs the question of what we can expect in 2015? The year-on-year change

will be modestly lower but by that time global GDP is likely to have accelerated to

its highest growth rate for five years. Much like the middle of the 1990s, the stage

is set for a new profits cycle to emerge amid a background where corporates still

caution against a lack of visibility. That period witnessed five consecutive years of

double-digit equity returns; we are currently in the middle of year two.

Chart 1: Equities trade on year-ahead GDP delta

Source: S&P Capital IQ Equity Research; Global Insight; 9 December 2013

The relationship holds true across countries for 2014 and upon factoring in Global

Insight’s, an independent economic consultancy, 2015 GDP growth forecasts the

greatest value opportunities overwhelmingly appear across the periphery.

Of course, once steady-state GDP growth is reached equity performance can and

does climb higher but the pace softens. For example, during 2004-06 global GDP

growth was consistently in a range between 3.5-4% during which time the SXXP

appreciated by 45% in price terms. Forward valuations contributed 5%, earnings

40% (22% revenues, 18% margin expansion). Global GDP could hit a steady-state

growth rate by 2015; in this scenario it is unlikely the European corporate

profitability will have peaked.

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Go Forth And Multiply We maintain our conviction that 2014 will be the first credible recovery year of

the developed world economies collectively and, crucially, the first of many.

Private sector surveys coupled with a reversal in net fiscal tightening1 points

towards global GDP growth rate above 3.5% from 2.5% currently – the largest y-o-

y delta in growth since 2009 (and 2004 before that). We are entering our third

recovery year in the past decade in Europe, reflecting a period of shortened

business cycles when viewed historically and offering the potential of a

prolonged period of expansion, conditional on a less volatile economic

landscape. Global GDP growth has obviously been stronger than in Europe but

has still been on a declining path since the second quarter of 2010, and hence we

view it more likely than not that growth will positively surprise to the upside.

Chart 2: PMIs suggest global GDP acceleration into 2014

Source: Markit, Bloomberg; 9 December 2013

Be it the shadow banking system or suboptimal political architecture, the recent

past advises against ignoring exogenous shocks. 2014, however, looks light on

banana skins, at least relatively. For a start, the political calendar is clear: US

mid-term elections fall in November 2014 while December 12 of this year and

January 13, 2014 are the next dates scheduled for the US debt ceiling debates;

otherwise, the next key election in Europe is most probably whenever Italy

decides to go back to the polls. These events are unpredictable but the

diminished contagion effect in financial markets alongside a weaker capacity for

influence tactics by Silvio Berlusconi comfort us.

The fact the US Republicans are perceived serial offenders in the eyes of the

voters, judged by their subsequent performances in the polls, leaves their

negotiating position heavily compromised with the mid-terms now months away.

Further, the Continuing Resolution, the remaining bones of contention, has

narrowed given the various piecemeal agreements reached thus far. During all

this, the US economic recovery is broad-based across sectors and ready to

accelerate in 2014 in our view.

1 Year-on-year change in public spending (ie. a fiscal deficit moving from -2% to 1% of

GDP would result in a positive fiscal impulse of +1%)

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But where does growth come from in Europe? The simple answer is that different

components of an economy grow, or contract, at different rates and the 2014

recovery is as equally attributable to some of those components not making a

negative contribution than others carrying the fight with renewed vigour.

Chart 3: Delta largest in periphery; y-o-y change in 2014/13

GDP growth on current forecasts

Chart 4: Weak credit demand coincident with moribund

economic recovery

Source: S&P Capital IQ Equity Research, Global Insight; 9 December 2013 Source: ECB, Eurostat; 9 December 2013

A balance sheet snapshot of European economies reveals a still-defensive

positioning: household savings are elevated, deleveraging continues and

corporate spending, on rehiring or investment, is on hold. The capacity for future

expansion is significant. An even more positive picture develops when viewed

through the lens of an income statement: credit conditions are easing for both

households and non-financial corporates2 (NFCs) driving a credit impulse via

lower costs of funding ahead of increased lending, retail sales are rising across

most of the big European economies over the past two quarters; fiscal impulses

will be generated in Germany, Italy and the UK3 and exports will be supported by

the cyclical improvements in both the US and China. The largest year-on-year

improvements will be visible in the peripheral economies (chart 3).

The link between these income statement and balance sheet analogies is the

inventory cycle. In Europe, it has explained much of the weakness since 2010 and

will provide the ignition to the economic engine in 2014, in our view. Working

capital demand, modelled as the future change in corporate credit in the ECB’s

quarterly Credit Conditions survey, has rebounded to positive territory for the

first time since the third quarter of 2011.

2 NFC conditions eased in October for the first since 2007 3 Forecast net fiscal tightening for 2014/2013 as a percentage of GDP are 0.7ppts for

European Union. The US is more than double at 1.6ppts according to the IMF.

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GDP Forecasts Stable And Likely To Be Upgraded Consensus GDP growth forecasts were downgraded heavily throughout 2012, by

roughly a full percentage point (ppt) for both France and Germany, 1.5ppts for

Italy and a whopping 2.5ppts for Spain. 2013 forecasts have been both better and

more divergent: Spain has been upgraded by 0.2ppts since the start of the year

along with the UK, Italy down by 1ppt and France and Germany have recovered

mildly after mid-year downgrades. Current 2014 GDP growth forecasts have been

fairly stable across all the key EZ economies throughout 2013 bar the material

upgrades to the UK in H2 (from 1.6% to 2.3%).

Our S&P Capital IQ European Economics team is slightly below consensus on the

UK, at 2.1% GDP growth for 2014E, but similarly sees it as the strongest 2014

performer followed by Germany with 1.8%. Growth is then seen peaking in the

latter, with biggest year- on-year changes going into 2015 found in France and

Spain. The recent weakness in EZ inflation is viewed as temporary, but the

subdued inflationary pressures are not as the ECB target of ‘close to but below

2%’ will not be challenged until 2016 at the earliest in their view.

Table 2: Main economic forecasts

Source: S&P Ratings; 31 October 2013

An interesting footnote to the prolonged recessionary conditions in Europe is that

most of the peripheral economies endured the first wave (Great Recession, 2008-

09) better than they did the second wave (Eurozone sovereign crisis and

consequent deleveraging). Public sector spending attempted to offset private

sector contraction in the former but alas this dynamic didn’t reverse in the latter,

as it did in the US. As European public sector growth stabilises in 2014, we

anticipate a strengthening private sector rebound as the year progresses with

significant catch-up potential on offer (chart 5).

Oxford Economics currently puts the Eurozone output gap at -4.2%, making it the

largest among the developed world (only just below the UK). Interestingly, the US

output gap of -3.45% is larger than the OECD average of -2.9% and suggests that

the US recovery is still in its early form. Within Europe, Norway is the solitary

Real GDP (% chng) Germany France Italy Spain U.K. Eurozone

2012f 0.7 0.0 -2.5 -1.6 0.1 -0.6

2013f 0.5 0.0 -1.8 -1.5 1.5 -0.7

2014f 1.8 0.7 0.5 0.5 2.1 0.9

2015f 1.7 1.4 0.9 1.1 2.0 1.3

CPI inflation (%)

2012f 2.1 2.2 3.3 2.4 2.8 2.5

2013f 1.6 1.0 1.5 1.8 2.7 1.6

2014f 1.8 1.5 1.6 1.4 2.3 1.6

2015f 1.7 1.4 1.2 1.3 2.0 1.5

Unemployment rate (%)

2012f 5.5 10.3 10.7 25.1 8.0 11.4

2013f 5.4 11.0 12.2 26.7 7.9 12.4

2014f 5.2 11.0 12.5 27.0 7.8 12.5

2015f 5.1 10.3 12.0 26.0 7.5 12.0

8



nation with a positive output gap, of 0.8% (the rest of the Nordics are between -

2.8% and -5%). Germany (-0.9%) has the smallest output gap among the key EZ

members followed by Italy (-2.5%), France (-4.7%) and then Spain (-6.3%).

These unobservable judgements may be treated with a pinch of salt following the

non-alarm bell ringing ahead of the Great Recession although the current lurking

dangers of the shadow banking system are further from the shore by comparison.

Nonetheless, from an equity perspective, output gap forecasts may be a better

sell than buy signal4 and they are clearly not indicating an overheated cycle, in

our view. Another approach to quantifying, or timing, the levels of spare capacity

is the Taylor Rule used by monetary economists (where interest rates are set

based on the dynamic between inflation and GDP growth and the respective gaps

between actual and potential levels). Using IMF assumptions5 on the non-

accelerating rate of unemployment (NAIRU), the optimal interest rates for the

individual economies are: 4.3% (Germany), -0.3% (France), -2.5% (Italy), -12%

(Spain) and -1.6% (UK). Rates markets are currently pricing first BOE and ECB

hikes in Q1 2015. What is evidently clear to us in regards to the latter is monetary

policy will have to be a closer fit to the weaker members of a monetary union

where exit is not allowed than to the stronger performers. Under this framework,

Germany is more likely to overheat than the periphery is to struggle, which

augurs well for our investment horizon.

Chart 5: EU private sector recovery has commenced Chart 6: OECD output gaps

Source: S&P Capital IQ Equity Research Eurostat; 9 December 2013 Source: OECD, Oxford Economics; 9 December 2013

4 We can use the high-frequency PMI series for further illustration: one may buy equities

when the PMIs are around 45, ahead of an economic recovery, and typically be

profitable – hence a good buy signal. The same principle for selling does not apply

when PMIs peak in the high 50s. 5 Germany 7.8%, France 8.9%, Italy 8.2%, Spain 13.5% as of November, 2013

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Investment Rebound Requires A Couple More Quarters Of Steady Improvements

Financial crises are synonymous with periods of under-investment as balance

sheets are repaired and credit conditions take longer to normalise. The 2008-09

downturn was most definitely an investment-led (prolonged) recession and gross

fixed capital formation (GFCF) in the Eurozone is currently 16.1% below trend.

The picture is more stark at the national level: Spanish GFCF is 33% below Q1

2008 peak levels, Italy and the UK 25% below and even the mighty Germany is

below peak (-5%).

Chart 7: Gross fixed capital formation rebased by country Chart 8: Greatest catch-up potential in fixed investments

Source: S&P Capital IQ Equity Research; Q1 2008 = 100; 9 December 2013 Source: 9 December 2013

But just because those levels are depressed, is that enough to warrant a rebound

in our forecast horizon? Firstly, it is important to identify the primary

determinants of investment spending: capacity utilisation (CU), costs of finance

and corporate profits. CU levels have recovered to mid-to-high 70% in a host of

European countries and could conceivably cross the 80% threshold in the next 12

months given that our 2014-15 GDP growth forecasts are 0.9% and 1.3%

respectively. Financing costs have improved markedly since President Draghi’s

‘irreversibility of the euro’ speech of July 2012 and have scope to go further.

Peripheral SMEs admittedly are still credit-constrained but their primary cause for

concern in the ECB’s latest Access To Finance survey6 is cited as end demand.

Again, this should incrementally improve as we progress into 2014. Their October

quarterly credit conditions survey showed corporate lending standards turned

positive (i.e. eased) for the first time since 2007 (ignoring the short-lived, flat

reading in mid-2010, chart 10). Corporate lending is weaker currently (-5.2% y-o-y)

than after the Great Recession of 2008-09, moving from a halt in loan growth to

eventual deleveraging. Lastly, our 2014 base case for European equities is

constructed on an earnings rebuild and hence all criteria for an investment

rebound appear in place.

Chart 9 highlights the role of GFCF. It is typically 3-4 times more volatile than the

GDP cycle and hence plays a significant role in the amplitude of the business

cycle.

6 October 2013, semi-annual publication

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Germany France Italy Spain UK

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10



Chart 9: Gross fixed capital formation amplifies the GDP

growth cycle

Chart 10: Deleveraging should be into final year

Source: S&P Capital IQ Equity Research; 9 December 2013 Source: ECB, Eurostat; 9 December 2013

Depressed investment activity levels vary according to the different performances

of the past cycle and if it was overheated or not. The greatest surprise at the

country level is not that the likely bunch of the UK and Iberia are furthest from

their long-term proportion of investment within their economies but that France

is above (chart12). A more detailed cross-section shows France outperforming

Germany across all categories, Iberia ranks bottom in most while Italy’s weakness

is closely matched to the UK’s dynamic. We provide further granularity on the

basket of fixed asset expenditure below:

Dwellings (residential): The hardest hit category in the EZ. Portugal

(-66%), Spain (-46%) and the Netherlands (-35%) stand out as the most

severe adjustments by far and with house price inflation still negative in

all it is likely that none have troughed. The UK (-6%) has been

surprisingly resilient given the strength of house prices over the past

decade while Sweden’s (+25%) later housing boom raises concerns.

Intangibles: Makes up 9.3% of total fixed asset investment and is 7.6%

above average levels in the EZ but weak in the UK (-10%), Finland

(-13.8%) and Spain (-14.8%). IT capex should leverage from the more

traditional capex investments but the rebound will be stronger

elsewhere.

Machinery & Equipment: Makes up approximately 26% of total fixed

asset investment, alongside the other two big heavyweight segments

dwellings and other buildings and structure. Germany, Italy and Sweden

have particularly large weighting.

Other Buildings & Structures: Incorporates government expenditure on

items such as municipal buildings or bridges among other things and the

shape of the country deviation from long-term average mirrors that of

the respective sovereign’s fiscal deficits barring a strong performance in

France. Sweden is above trend, the EZ is 9.5% below and dragged lower

by Spain (-26%) and Portugal (-31%), while the UK is 23% adrift.

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Credit conditions tightening

Credit conditions easing

11



From modelling signals from business surveys on economic sentiment, we are

optimistic that European GFCF will accelerate into 2014 and beyond (charts 11).

The impulse is strongest in the UK, Germany and Spain within Europe but Italian

signals instead point towards greater stabilisation.

Chart 11: EU investment spend to accelerate in 2014 Chart 12: Non-residential share of GDP versus long-term

averages lower across Europe

Source: S&P Capital IQ Equity Research; 9 December 2013 Source: Eurostat, 9 December 2013

Europe is not alone in the improving GFCF outlook. The investment impulse in

the US is perhaps even stronger with our model pointing towards a high-single

digit growth rate and beyond over the next four quarters (chart 13). Reassuringly,

the bickering in Congress no longer has the same adverse impact on business

confidence that it did in the preceding quarters before the first ‘fiscal cliff’

negotiations. Our positive model readings are supported by private sector

confidence at elevated levels; Philly Fed Capex Intentions, in tune with the Empire

State and Richmond Fed Capex surveys, was at its second highest reading since

2004 as recently as September, when the Conference Board Consumer Confidence

index is at a six year high too. Both have pulled back since but they remain in

healthy territory and the ISM has accelerated since.

Chart 13: US investment spend to accelerate in 2014 Chart 14: US private sector confidence at multi-year highs

Source: S&P Capital IQ Equity Research; 9 December 2013 Source: Federal Reserve, US Census Bureau; 9 December 2013

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ECB Will Figure Prominently, Has Capacity To Positively Surprise

The ECB finds itself in the rare position of cleaning up a mess they weren’t

directly responsible for. This afforded luxury coupled with the transfer towards

the Single Supervisory Mechanism grants the ECB greater scope in tackling the

legacy loan issues of the Eurozone banking system and the risks of

‘zombification‘ of its weaker members.

The Asset Quality Review and subsequent stress test, scheduled for completion

by the end of H1 and Q3 respectively (but not published until October), will be a

defining feature of 2014. It is difficult to determine whether the improving

economic conditions are cyclical or structural in nature at this juncture but the

need for this recovery to grow roots is beyond reproach. The largest banks are

likely to improve their provisioning ahead of the end-2013 cut-off date for

analysis; we are positive on the expected outcomes. The ECB remains vigilant,

evidenced by the surprise rate cut on November 7. Spurred by the disinflationary

trends pervasive in most of the developed world but most acute in peripheral

Europe, the Refi rate cut took 3% off the EURUSD rate.

Chart 15: Excess reserves in EZ banking system continue to

shrink

Chart 16: Euro appreciation as ECB balance sheet shrinks

Source: ECB; 9 December 2013 Source: Bloomberg; 9 December 2013

It is our view that the euro will be weaker versus both USD and GBP over the next

12 months, most likely in the region of 1.20-1.25 for both cross-rates. As we swap

a high volatility economic and financial landscape for a lower one, the euro is

less likely to display the risk-on, procyclical characteristics of recent times. A

strong current account performance will limit the depths of depreciation but

import levels should pick up as EZ consumers and corporates respond to the

more benign economic conditions.

We believe the key event for EURUSD will be when the US Federal Reserve finally

sets a timetable to taper – we believe this could be by the 18-19 March FOMC

meeting, although our US Economics team believe it could be sooner. The dovish

Janet Yellen is set to replace the equally-dovish Chairman Bernanke but one

should not overlook the other changes being made to the Board: seven of the 12

members are rotating in the coming months, most of those known doves. Hence,

7 Long-term refinancing operation

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the new ‘Yellen Fed’ is likely to be more hawkish if anything. Either way, the

Fed’s actions are tied to economic developments and, as the economy accelerates

in 2014 as we expect, it is arguable to claim that further stimulus is needed.

Assuming that rounds three and four8 don’t adversely impact the improving

recovery, the Fed’s March round of GDP forecasts are likely to be upgraded9 and

could provide a perfect platform to justify the diminished need for further QE, in

our view.

Chart 17: US Treasury yield adjustment is nearly complete

Source: S&P Capital IQ Equity Research, Bloomberg; 9 December 2013.

Despite the enforced delay to the Fed’s original timetable, most of the market

adjustment has already occurred this year making focus on ‘taper’ less relevant.

Our 10-year US treasury model perfectly captures the distortion of QE between

Q3 11 and now. The market has digested a 100bp move in yields over the past six

months and a further rise, on the shoulders of stronger growth, should not

provoke a repeat of the 22 May equity sell-off. Or perhaps, with no future element

of surprise, it’s less relevant for equities than it is for credit markets10.

The same logic cannot be applied to the EZ. The reason we believe the ECB will

move deeper into accommodative policy is twofold: it remains on high alert (it is

difficult to envisage the surprise rate cut on November 7 during the Trichet years)

and, put simply, it needs to be.

8 Next key dates for the US debt ceiling debates are December 12, 2013 and January 13,

2014 9 Latest 2014 GDP growth projections are for 2.9%-3.1% 10 The biggest correction occurred in EM bonds, US HY and govvies – the classes that

attracted the largest mutual fund inflows since 2009.

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UST 10yr Yields (%, lhs) Model 10yr Yields (%, rhs)

14



Chart 18: Access to Finance Q4 2013 survey Chart 19: % economy constituted by SMEs

Source: S&P Capital IQ Equity Research; ECB Access To Finace Survey, October 2013. Source: S&P Capital IQ Equity Research, OECD, 2011.

The composition of the EZ economies acts as a potential handbrake on the

recovery, or an accelerator to it. SMEs play a significantly larger role in France

and the periphery than their G7 counterparts (chart 19). This mattered little in

times of plenty but the current stresses are captured neatly in the ECB’s semi-

annual Access to Finance surveys; 50% of Spanish SMEs, for example, remain

credit constrained according to October’s report. A similar story is told in Italy,

Portugal and Ireland. The sovereign-bank-corporate nexus is the thread that ties

all this together: higher sovereign reference yields adversely impact domestic

corporates with weak profits and a debt overhang, driving domestic banks’ NPLs11

higher and compressing already-thin capital buffers and overlaid by higher

funding costs via the sovereign’s credit profile. We have a strong belief that this

nexus shall weaken over the coming 12 months and beyond.

Chart 20: Credit conditions suggest greater confidence in applications

Source: ECB Credit Conditions Survey, October 2013.

11 Non-performing loans

0

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Germany France EZ Italy Portugal Spain Ireland

% SMEs That Report Credit Constraints

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Sweden Germany US UK Japan Canada Italy France Spain Portugal

SME Contribution to GDP (%)

-40

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Jul-11 Jan-12 Jul-12 Jan-13 Jul-13

ECB Corporate Loan Demand (last 3mth chng) ECB Consumer Credit Demand (last 3mth chng)

%, net balance

15



The good news should arrive in three forms:

SME’s most pressing problem was and is the lack of end demand, according

to the same Access To Finance survey, and this will sequentially improve

from hereon in, driving internally generated funds.

Improving credit conditions for both households and corporates alongside

cleaner banks’ balance sheets (post AQR, stress tests and forced

recapitalisations) by the end of H2 2014 offer some light at the end of the

tunnel.

The ECB’s relaxation of collateral requirements on SME-related asset-backed

securities, from AAA to A, in July 2013, acknowledges their recognition of the

problem and their unorthodox willingness to offer solutions.

Most market participants usually scoff at the results of bank stress tests, given

that the larger, listed banks are ascribed a clean bill of health and the smaller,

unquoted and de facto face-less banks are highlighted and given most support. If

this turns out to indeed be the case, our positive argument is wholeheartedly

buttressed: second-tier and small banks in the weaker countries are facing the

greatest wholesale funding strains and it is these banks that provide the bulk of

SME lending.

A worthy headline to this chapter is that the EZ era of deleveraging may be in its

final year judging by the results of October’s credit conditions survey. Lending

conditions for non-financial corporates (NFCs) eased for the first time since 2007

(highlighted by a negative reading in chart 10). On a simple relationship, NFC

lending annual growth rates could improve from -5.5% currently to 0% in four

quarters time. The debt overhang will persist in many corners of Europe but

greater success will be garnered from rising collateral and income levels

however. The cessation in total loans shrinkage is a worthy flag for this acute

phase of deleveraging.

A Chill Eastern Wind … In our view, China represents the biggest downside risk to our European equity

outlook. As both Europe and the US exit their periods of adjustment, China is

perhaps next in sequence to redress the imbalances in its growth model and,

more prosaically, remains more of a known unknown.

The quality of growth in the 2011-13 period has deteriorated dramatically and the

credit intensity of GDP remains elevated due to overheated housing and

investment. The IMF employs a 10% deviation from trend as a threshold for credit

bubbles and China’s credit growth is now 26% above that trend.

16



Chart 21: China credit intensity of GDP Chart 22: China private sector debt to GDP 26ppts above trend

Source: S&P Capital IQ Equity Research; 9 December 2013 Source: Bloomberg; 9 December, 2013. Orange line includes total social financing.

This bubble in housing poses risks but less than the recent western experiences.

Roughly half of Chinese house purchases in recent years have been all-cash

transactions hence a house price crash is less likely to impair the banking system

akin to Ireland, Spain or the UK. This is not to dispute the worsening domestic

asset quality of Chinese banks however; a 56% investment share of GDP can only

be explained by state-directed credit flows in our view. Note that both South

Korea’s and Japan’s investment-led booms during their industrialisation phases

peaked at significantly lower levels12.

Most European stocks with Chinese industrial exposure have lagged the broader

market throughout 2013, and they will continue to do so in our view. The crux

here, however, is the potential for a China-inspired global slowdown to expose

the current fragility of the European recovery.

12 Korea’s investment share of GDP peaked at 38% in 1991, Japan 36% in 1973

0

3

6

9

12

Q4 1999 Q4 2001 Q4 2003 Q4 2005 Q4 2007 Q4 2009 Q4 2011

Credit Intensity (Unit of Credit Per Unit Of GDP)

Ratio

40

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180

Dec‐83 Dec‐86 Dec‐89 Dec‐92 Dec‐95 Dec‐98 Dec‐01 Dec‐04 Dec‐07 Dec‐10 Dec‐1

China Private Sector To GDP (%)

17



Chart 23: Excess capacity evident In PPI Chart 24: China investment share of GDP

Source: S&P Capital IQ Equity Research, Bloomberg; 9 December 2013 Source: Bloomberg; 9 December 2013

… Insulated By Reform? Reassuringly, in our view the counterbalance to these developments comes from

the China Third Party Plenum (TPP) held on November 9-12. Similar to the 1978

and 1993 TPPs13, comprehensive market reform programmes were announced

that could radically alter China’s growth potential from its current slowdown. The

relationship between government and the market economy has been the key

problem and while no explicit directives to break up the existing state-owned

enterprises (SOEs), greater emphasis will be placed on redirecting credit away

from inefficient SOEs and towards previously credit-constrained (judging by the

rapid growth of the shadow bank sector) and more efficient private enterprises.

Key sector reform initiatives include:

Rural land – endorsing the rights of farmers, particularly in the

ownership of their land.

Financial – interest rate liberalisation and RMB internationalisation.

Labour – immigrant residency rights (‘Hukou’) will be relaxed in mid-

sized cities, as will be the ‘one child policy’.

Private enterprise – reduce crowding out by SOEs and less approval for

local government projects, in favour of more free trade zones (FTZs).

Local government clampdown – provincial corruption investigations will

now involve the Central Disciplinary Commission, the labour camp

system has been abolished and the interference upon provincial law

courts has been made more difficult.

13 Premier Xiaping focused on deregulating agriculture and liberalising the rural

economy in 1978, and opened up China for business with the outside world in 1993.

‐30

‐15

0

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45

60

‐15

‐10

‐5

0

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Apr‐02 Apr‐04 Apr‐06 Apr‐08 Apr‐10 Apr‐12

PPI Industrial Products PPI Raw Materials (%y/y) Exports (3MA, %y/y, rhs)

10

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50

Dec‐80 Dec‐85 Dec‐90 Dec‐95 Dec‐00 Dec‐05 Dec‐10

China Japan Korea US EU

% of GDP

18



The language of the Decision Document has been viewed as stronger than

expected by seasoned China observers. Reading between the lines its greater

potency than more recent editions highlights the limited room for manoeuvre of

the current growth model – one which has lacked clear growth drivers since the

Great Recession. The heavy clampdown on the ambitions of local government,

primarily responsible for the rising credit intensity of GDP that we have flagged,

should see the acceleration in credit-to-GDP ease. We think financial sector

reform is a big positive for both the private sector and its banks and also

improves the financial stability outlook.

But just how long will these reforms take to be implemented? SOEs may face

greater competition but there was no discussion on the break-up of the various

monopolies. Likewise, RMB internationalisation could rebalance China’s economy

from investment towards consumption in a near stroke of the pen but it will likely

be enacted in pigeon steps. Hence, from a European equity perspective, the TPP

is enough to raise our view on China-exposed names from underweight to

marketweight but not enough for a more positive view at this juncture. Again, we

remain consumer-focused.

19



Banking System Holds The Key

Greater Financial Stability 2014 will be a historic year for the ECB, culminating in the stewardship of the 128

largest banks in the EZ from November. To put the foundations in place, the ECB

will address both the assets and liabilities of the Eurosystem separately, we

believe. The Asset Quality Review (AQR) is scheduled to run throughout H1 2014

with a key objective of harmonising accounting and regulatory practises across

borders. Current definitions of non-performing loans or those in forbearance are

too heterogeneous, in our view. The recent change in treatment of deferred tax

assets and the inclusion towards common equity capital by the Spanish

regulators has long been accepted by their Italian counterparts is a case in point.

It does offer hope that like-for-like comparisons across Europe will be less opaque

and challenging moving forward.

Capital levels have continued to strengthen for the euro area banks, with the

median core Tier 1 capital ratio increasing to over 11% in Q3 13 up more than

four percentage points over the past four years. Further, the majority of euro area

banks have already reached a 9.5% Basel III fully loaded compliance level for

Global SIFI14 (4.5% Core Tier 1 + 2.5% conservation buffer + 2.5% maximum

Global SIFI buffer) ahead of the 2019 deadline. However, there is continued

uncertainty with regard to the application of risk weightings leading to increased

focus on the leverage ratio. Improvements here have been more modest and euro

area banks are in a weaker position relative to the US even after adjusting for

netting differences between IFRS and US GAAP. With non-performing loans

continuing to rise, there remains the risk of capital measures for banks where

capital ratios are low and profitability is subdued. We believe the ECB’s

Comprehensive Assessment is a key opportunity to increase confidence in banks’

balance sheets to harmonise risk weightings as well as recognition of non-

performing loans and provisioning.

The downside risk in addressing the legacy loan issues, and the consequent

‘zombification’ of economies that haven’t sufficient deleveraged, is capital

dilution to existing shareholders we think. It is a plausible view that raising

capital at the beginning of an economic recovery is a different proposition to

doing so when the world was burning in late 2008 and 2009 and solvency fears

are very real.

Recently, Barclays raised GBP5.8 bln through a rights issue announced at the end

of July 2013 to help cover a GBP12.8 bln capital shortfall to reach a PRA15

leverage ratio of 3% (stressed to include estimated future conduct costs and

write-downs on the banks’ riskiest assets) by June 2014. The remainder is to be

met through further deleveraging, issuance of hybrid debt and retained earnings.

As a result, Barclays pushed out its return on equity target exceeding cost of

equity until 2016. The shares fell 10% in response to the announcement and

subsequently underperformed reflecting concerns around difficult trading

conditions in the investment bank and particularly fixed income trading, further

misconduct provisions and ongoing uncertainty with regard to capital

requirements for the UK banks following a PRA consultation paper implementing

14 Systemically Important Financial Institutions 15 Prudential Regulation Authority

20



CRD IV16. The last point illustrates both balkanization in regulation and the lack of

visibility over regulation as banks aim to meet moving capital hurdles. The PRA

are due to finalise their paper in the coming weeks which will bring further

clarity.

While leverage ratios in the southern European banks are less of a concern, the

key issue relates to asset quality. Hence, the IMF has also analysed the potential

banking system losses from their corporate exposures, over the cumulative 2014-

15 period in Italy, Portugal and Spain, against their estimated total loss-

absorption capacity (current provisions, future pre-provisions earnings and

capital buffers)17.

Their conclusions can be summarised as follows:

Spain: EUR104 bln gross corporate loan losses, fully covered by existing

provisions.

Italy: EUR125 bln, which exceeds existing provisions by EUR53 bln but

fully covered by future operating profits (ergo no capital erosion).

Portugal: EUR20 bln, EUR8 bln above existing provisions and similarly

fully covered by future operating profits.

Additional losses for each using their alternative 55% LGD assumption,

from their 45% estimates, are EUR33 bln, EUR28 bln and EUR4.4 bln for

Spain, Italy and Portugal respectively.

Chart 25: Potential losses on corporate loans & banking

system buffers

Chart 26: Total loss absorption capacity of Italian and Spanish

banks under S&P Capital IQ’s coverage

Source: IMF Global Financial Stability Report, October 2013 Source: S&P Capital IQ Equity Research estimates; 9 December 2013.

16 Capital Requirements Directive, applied to European banks by the European

Commission 17 IMF key assumptions include an extension of weak current economic conditions (ie,

ignoring their baseline forecasts for a recovery and a standard Basel loss-given default

(LGD) of 45%. 18 Bank of Italy have undertaken their own analyses

0

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Spain Italy Portugal

45% LGD 55% LGD Provisions (Corporate) + FY14‐15 Operating Profits Tier 1 Capital

EUR (bln)

Provisions

Operating Profits

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70

Santander BBVA Intesa Sanpaolo Unicredit

Provisions FY14‐15 PTPPP CET1 Capital Tier 1 Capital

EUR (bln)

21



This raises a further concern for Italian and Spanish banks that have responded to

revenue pressures from deleveraging of loan books and rising non-performing

loans in their domestic markets by increasing their exposure to the domestic

sovereign debt. The ECB Financial Stability Report (November 2013) highlights

that aggregate bank exposure to sovereign debt in Italy and Spain now makes up

10% and 9% respectively of total assets – a position that is far higher than the

core European countries and an increase of two and nearly three percentage

points from the position a year earlier. Banks have further benefitted from the

zero risk weighting of local-currency government bonds to improve capital ratios.

While this treatment will apply to the asset quality review, we hope that some

haircuts will be applied in the subsequent stress tests although we await further

clarity and this looks to be a point of contention between Bundesbank and ECB.

When we look at our coverage of banks in Italy, we echo the IMF findings with

coverage levels in Italian banks looking low relative to Spain which has already

gone through its own stress tests last year and increased provisioning on real

estate assets following clean-ups required by Royal Decrees. NPL recognition is

more stringent in Italy but coverage levels at between 40% and 50% for Intesa

and Unicredit are below the 60%-70% range for Banco Santander and BBVA. Pre-

provision profitability is higher in Santander and BBVA supported by their

geographical diversification offsetting problems in their home market. However,

we believe capital levels are stronger in Italy following rights issues at Intesa and

Unicredit over the last two years and valuations are more supportive.

On completion of the AQR, the banks will be stress tested in Q3 14. The chain-

linking of higher quality and higher capital needs is captured by the raised capital

hurdle rate of an 8% common equity tier 1 (CET1) ratio, versus 5% used in the

most recent EBA exercise in 2012. The credibility of these exercises always hinges

on the severity of the adverse scenario, the translation impact on banking books

(sovereign default will not be considered but their price movements will, for

example) and the subsequent co-ordination of recapitalisations. If no private

capital is forthcoming, then national backstops will be put in place. This, of

course, is the precursor to the ECB assuming its role as the Single Supervisory

Mechanism (SSM) in November 2014.

For the sake of completeness, these positive developments are not to be confused

with the schedule for a fully-fledged banking union. The ECB will not have the

authority to wind down any bank deemed to be failing until the Bank Resolution

and Recovery Directive (BRRD) gets passed into law during 2015, and even then a

pan-European resolution is both absent and unfunded. A template for bail-in

hierarchy has been agreed however: equity shareholders will suffer the first

losses, then junior and hybrid bondholders before a sovereign can inject fresh

equity. Theoretically, senior unsecured bondholders and depositors above

deposit guarantee scheme thresholds are also at risk although unlikely.

Points of Reference: Nordics & US No western nation can claim to be untouched when it comes to banking and

financial crises but changes in structures, both within modern economies and

between them, make comparisons more challenging. The Nordics financial crises

of the early 1990s has been widely trailed given the success of the response

mechanisms used: establishing independent funds to inject capital into the

banking system (Finland), nationalisation (Norway), mergers of weaker banks and

subsequent separation into ‘good’ and ‘bad’ banks alongside blanket guarantees

(Sweden).

22



Chart 27: Nordic bank lending followed two years after the recovery in house prices

Source: S&P Capital IQ Equity Research, IMF Global Financial Stability Report, October 2013

Like the divergences within the current Eurozone it is remiss to cast the Nordic

crises as uniform. Using 1985 as a base date for all, Finland witnessed the

strongest house price boom, climbing 60.5% in real terms before peaking in mid-

1989; prices fell 47.6% subsequently over the following 16 quarters. Swedish

house prices rose 39.7%, peaking later in 1990, before falling 31.1% over the

following 23 quarters. Norway witnessed a 31.4% rise in real house prices that

peaked nearly three years before the other two countries, then inevitably losing

39.6% over the next 23 quarters.

The key takeaway, however, is that bank lending levels didn’t increase from their

trough for eight, 12 and 13 quarters for Finland, Norway and Sweden respectively

(chart 27). During this period bank equity prices rallied in all territories. At this

juncture, the direction is more significant than the magnitude in our view.

Chart 28: US NFC loans versus house price recovery Chart 29: Which was similar to the timeline of the US

experiences of early 1990s and 2000s as well as 2008-10

Source: S&P Capital IQ Equity Research, Bloomberg; NFCs = non-financial corporates; 9 December 2013

Source: S&P Capital IQ Equity Research; NFCs = non-financial corporates; 9 December 2013

The US timeline corroborates the Nordics experience; after the strong official

sector leadership in 2009, solvency and liquidity issues were assuaged and bank

equity prices have more than tripled since that first quarter low. Household

100

150

200

250

300

350

400

1984 1986 1988 1990 1992 1994 1996 1998 2000

Finland Bank Lending Norway Bank Lending Sweden Bank Lending

Rebased

90

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Mar‐00 Mar‐05 Mar‐10

Total Outstanding Commercial & Industrial Loans (USD, mlns) S&P Case Shiller 20 (rhs)

4yrs for NFC loans to pick up

6qtrs for NFC loans to pick up

7,000

9,000

11,000

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15,000

17,000

400,000

700,000

1,000,000

1,300,000

1,600,000

1,900,000


Total Outstanding Commercial & Industrial Loans (USD, mlns) US GDP (2009 Dollars, SAAR, USD trn, rhs)




23



lending will typically pick up before corporates in any pre-recession due to their

differing objectives: the former will primarily want to take advantage of cheaper

mortgage rates, while the latter will wait for a sustained pick-up in aggregate

demand. Recall it was the household, not the corporate sector that was

overleveraged in the most recent downturn (the reverse was true in 2000) and

consumer spending recovered once house prices found a bottom. By six quarters

later in Q3 2010, total outstanding commercial and industrial loans started

expanding again and managed to retrace the 22% fall by early 2013 (now 7%

above). Analysing the past three US recessions (1990, 2000, 2008), it took 10, 10

and six quarters of improved aggregate demand before corporate lending

restarted. If we apply this time frame to the EZ and pivot it on the recession

ending in Q2 13, corporate lending should increase part way through 2015.

Provisioning Cycle Is Paramount US banks have seen their EPS quadruple between 2009 and 2012. The US driver

has been the release of provisions – credit growth didn’t appear until 2012. So

what flexibility do European banks have to drive P&L by the release of built-up

provisions?

The appropriate level of provisions held in proportion to pre-tax pre-provision

profits (PTPPP) and total loans (TL) of course varies depending on which stage of

the cycle we are in. The answer can also vary by geography: US provisions to

PTPPP and TLs are 11% and 0.1% respectively as of Q3 2013, in line with the

previous mid-cycle profile. In aggregate, the EZ provisions cycle is consistent

with 2004-06 levels at 20% of PTPPPs and 0.5% of TLs. These are above current

US levels (which interestingly are similar to Europe’s profile in the 1990s).

Chart 30: Italian provisions cycle Chart 31: Spanish provision cycle

Source: S&P Capital IQ Equity Research, Bloomberg; 9 December 2013 Source: S&P Capital IQ Equity Research, Bloomberg; 9 December 2013

Italian and Spanish banks appear best positioned for any acceleration of

provisions into net income, however, provided that the AQR doesn’t delay their

likely peak too much. Italian provisions were 71% of PTPPP and 1.34% of TLs by

Q2 13 versus mid-cycle averages of 20% and 0.4% respectively; for context, the

two largest Italian banks have been collectively averaging EUR 400mln of net

income quarterly since the end of 2011 and a return to normalised provision

0.0

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Dec-90 Dec-94 Dec-98 Dec-02 Dec-06 Dec-10

Provs / PPPTP (%, lhs) Provs / Total Loans (%, rhs)

%

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Dec-90 Dec-94 Dec-98 Dec-02 Dec-06 Dec-10

Provs / PPPTP (%, lhs) Provs / Total Loans (%, rhs)

24



levels would equate to EUR 8.6bln of provision release assuming static loans.

This would likely take two to three years to complete barring no new recession.

The equivalent analysis for the Spanish banks shows provisions at 59% of PTPPP

and 1.7% of TLs and mid-cycle averages of 20% and 0.5% respectively. Total net

income has averaged EUR1.28 bln over the past six quarters meaning that a

provisions release of EUR13.8 bln could theoretically double current earnings for

11 consecutive quarters. There will inevitably be hiccups in that period but

nonetheless there is credence to current Spanish bank communications that they

do not fear the upcoming AQR.

By comparison, the French provisions cycle is at 30% and 1% (PTPPP, TLs);

German at 52% and 0.6%; and UK at 33% and 0.8%. All of these have peaked

before the Italian and the Spanish cycles but have room for further compression,

in our view.

Relative Earnings Momentum Should Drive EU Banks 2007: -6%. 2008: -35%. 2009: -24%. 2010: -5%. 2011: -23%. 2012: -22%. If you

haven’t guessed what the sequence is yet, it’s the brutal relative earnings

performance of European banks (SX7P) versus the SXXP. On current consensus

forecasts the next number in the sequence is +15%19. The issue can perhaps be

rephrased to the sell-side becoming bullish on banks but the buy-side community

have more scarred memories as the sector remains under-owned.

Relative EPS momentum finally turned positive at the start of this year, on the

basis that SXXP downgrades were deeper than that of the sector. Maintaining the

theme of catch-up potential, banks’ EPS levels are 43% below 2007 peak levels

against -20% for the broader market.

Chart 32: Rel EPS momentum turned positive in late 2012 Chart 33: Credit spreads lead higher bank equity EPS by two

quarters

Source: S&P Capital IQ Equity Research, Bloomberg; 9 December 2013 Source: S&P Capital IQ Equity Research; 9 December 2013

19 SX7P 2014E EPS growth of 30%, SXXP 14%, as at 9, December 2013.

40

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100


Earnings Rel Price Rel

2.0

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‐50

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100

Jan‐07 Jan‐08 Jan‐09 Jan‐10 Jan‐11 Jan‐12 Jan‐13 Jan‐14

EU Banks 12m Fwd EPS (lhs, %yy) EZ Banks 12m Fwd EPS (lhs, %yy) Euro BBB Corporate Yields (%, inverted, rhs)

25



On a more tangible note, lower funding costs drive net interest margins when

lending picks up and costs20 have fallen 14, 22 and 36 per cent for the Nordic, UK

and EZ banks over the past 12 months. Tightening credit spreads typically lead

bank EPS by two quarters and some of the upgrades have already materialised

(chart 33). We believe there is more to go.

Bank equity performance have also mirrored that of Senior Financials Investment

Grade CDS spreads, themselves 20% below previous cycle averages (chart 34), as

well as yields on Tier 1 bank bonds. We anticipate these tightening further in

2014.

Chart 34: Further CDS compression supports bank equity

performance

Chart 35: Funding costs lower and less fragmented

Source: S&P Capital IQ Equity Research; 9 December 2013 Source: S&P Capital IQ Equity Research, Bloomberg; 9 December 2013

As highlighted in the AQR discussion, it is sometimes folly to suggest that one

subset of banks are in a better position to outperform than others; UK and Swiss

banks, through earlier intervention, stand in better health than most EZ retail

banks. Then, perhaps for that very reason, most got hit with litigation fines

during the Q3 reporting season. Instead, we believe that the outperformance of

the sector will be broad-based although with a preference for French banks.

On a return on equity versus price-to-book basis one could conclude that Spanish

banks are expensive but we believe most are appropriately priced given their

profitability metrics.

20 Calculated using central bank base rates plus average CDS spreads across leading

domestic banks

0

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40040.0

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Jan‐11 May‐11 Sep‐11 Jan‐12 May‐12 Sep‐12 Jan‐13 May‐13 Sep‐13

Bank Equity Perf (lhs) Senior Financials IG CDS Spreads (rhs)

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Jan‐10 Jul‐10 Jan‐11 Jul‐11 Jan‐12 Jul‐12 Jan‐13 Jul‐13

UK Banks EZ Banks Nordic Banks

bps

26



Chart 36: ROE vs P/B

Source: S&P Capital IQ Equity Research; 9 December 2013.

Our Banks team expect French banks to undergo material 2014/2015

improvements due to less pressure on both deleveraging and asset quality,

allowing greater focus on profitability. We expect return on equity for the big

three French banks21 to improve by an average 185 bps by the end of 2015. Using

the slope of the relationship in chart 36, a 1.85 percentage point move would

equate to a re-rating from 0.9xTB to 1.1x – a 20% move.

21 BNP Paribas (BNPP FP, Strong Buy), Societe Generale (GLE FP, Buy), Credit Agricole

(CA FP, Hold)

Italy

Spain (rhs)

UK

France

Germany

Swiss

Sweden

0

2

4

6

8

10

12

14

0.4 0.6 0.8 1.0 1.2 1.4 1.6 1.8

ROE, %

P/B

27



Belated EPS Upgrade Cycle Finally Here

SXXP forward EPS forecasts peaked at EUR25 back in January 2011. 11 long

quarters later and the current forward EPS integer is down to EUR21.3 against a

backdrop of central bank-induced rising equity prices. Rising valuations have

hence explained most of the rally thus far. We are comfortable with 2014E/15E P/E

current valuations of 13.1 and 11.7 times as we believe we are on the cusp of a

material, multi-year earnings recovery.

10% Earnings Growth in 2014E Our simple PMI model, where the composite leads SXXP forward EPS by eight

months, points towards an integer of EUR24.2 by the end of 2014 –13.6% higher

than current levels with risks skewed to the upside, in our view. The PMI is a

diffusion index where a calibrated reading above 50 signifies economic expansion

in the private sector (it excludes government expenditure). For corporate

earnings, however, 52 is a more significant threshold as it is at this level that we

have typically witnessed EPS upgrades. It is common in recoveries to see the PMI

series in the 55-60 range, such as in the UK currently, as inventory cycles unwind

and restocking occurs within industrial channels, and we believe there is scope

for 2014 to witness an improvement from November’s EZ reading of 51.7 in the

absence of exogenous shocks. It is for this reason that we believe risks are

skewed to the upside.

We overlay this regression model by analysing producer price inflation and unit

labour cost (ULC) trends. Our alternative model focuses on the dispersion

between the two and suggests earnings growth between 12%-16% over the next

24 months (chart 37). The model uses OECD’s forecasts of 0.9%, 0.4% and 1.5%

annual changes in ULCs over 2013-15 as inputs and the latest PPI reading of -1.4%

y-o-y. PPI troughed at -5%, -3% and -2% in 2004, 2009 and 2012 respectively and

typically lags the GDP cycle by two quarters (as does the PPI-ULC cycle but with a

wider range). On this timetable, we expect to see PPI increasing from this point

onwards and also view this as providing scope for a multi-year earnings recovery.

It would also mark 2014 as the first year that consensus earnings, currently for

13% EPS growth, are achieved since pre-crisis.

We assume that FY/13 EPS stabilise at current levels of EUR21.3. Applying

earnings growth forecasts of 14% for both 2014 and 2015 results in a FY/15 EPS

integer of EUR27.7. Given the flow of funds support from other asset classes and

the expected low volatility in economic conditions, we are sanguine about using a

13.5 times forward multiple, giving us our 375 SXXP target price for end-2014.

28



Chart 37: EZ EPS model inflection point Chart 38: PMI composite leads SXXP fwd EPS by eight months

Source: S&P Capital IQ Equity Research; 9 December 2013. Assumes PPI of 1.2%, 3% and ULC of 0.4%, 1.5% in 2014-15.

Source: S&P Capital IQ Equity Research; 9 December 2013

The threshold for margin expansion varies by region but it is typically a 1% GDP

growth rate in Europe. Extending the analyses from above, profit margins

empirically expand the most when ULCs are falling; the converse is true when

labour inflation exceeds 2% y-o-y. The OECD forecasts used for our EZ EPS model

show ULCs growing 1.5% in 2015.

The margin cycle appears to have troughed in Europe following the Q3 13

reporting season, one which was defined by a weaker-than-expected top line and

more resilient earnings. Trailing EBIT margins are currently 5.6%, 60 bps above

the trough of the past three quarters. Two observations leap out of from chart 39:

one that the gap between US and EU profitability is large and likely to mean

revert and two, that profitability is not wholly depressed as one might think.

Current levels are consistent with the peak of 2011 and are 200 and 450 bps above

the previous two recessions. Record peak margins in 2007 look challenging but

fears of an artificially-boosted profit profile should be grounded versus the

current US performance, where margins have matched 2006-07 levels largely in

the absence of a credit cycle. Our margin proxy model points towards 70 bps

expansion at the EBIT level in FY 14 to 6.3%

‐12

‐8

‐4

0

4

8

‐50

‐25

0

25

50

Mar‐07 Mar‐09 Mar‐11 Mar‐13 Mar‐15

EPS growth (%y/y, lhs) PPI ex C ‐ ULC Inflation (rhs)

Forecast

30

35

40

45

50

55

60

65

13

18

23

28

Mar‐07 Mar‐09 Mar‐11 Mar‐13

SXXP Fwd EPS (EUR, 8m lead, lhs) EZ PMI Composite (rhs)

29



Chart 39: EU vs US EBIT margins Chart 40: EZ cyclicals EPS a beneficiary of a weaker euro

Source: S&P Capital IQ Equity Research, Bloomberg; 9 December 2013 Source: S&P Capital IQ Equity Research; 9 December 2013

Narrowing the gap between the US and Europe will be made easier when the

EURUSD rate weakens, as we expect it to once some confirmation on ‘taper’ is

given. EZ cyclicals would benefit disproportionately from such a scenario (Chart

40).

Biggest Margin Recovery In Cyclical Sectors & Periphery But Beware Traps We view Basic Resources (supply and cost inflation concerns), Oil & Gas

(expected oil price weakness and cost inflation), Telcos (persistent shrinking of

earnings capacity) and Utilities (depressed European power prices, excess

capacity) as structurally challenged rather than simply facing cyclical headwinds.

It would be unrealistic to expect any sizeable contribution to a European

profitability recovery, even if they may see some top-line recovery. Hence our

anticipated SXXP margin recovery is capped at only 30 bps. We expect the largest

contribution to come from Banks; current 6% ROE is lower than the entire

previous cycle and even the nadir of the 1993 recession. The long-term average is

just over 11%, which is a target outside our forecast horizon but low-hanging fruit

exist given how highly geared the sector is to a domestic European recovery.

Among the cyclicals, Travel & Leisure, Technology and Construction & Materials

have most catch-up potential, in our view.

0

3

6

9

Jan‐95 Jan‐98 Jan‐01 Jan‐04 Jan‐07 Jan‐10 Jan‐13

MSCI Europe S&P 500

% 112

117

122

127

132

137

142

14790

100

110

120

130

140

150

160

Jun‐09 Jun‐10 Jun‐11 Jun‐12 Jun‐13

EZ Cyc/Def EPS (index, lhs) TWI Euro (index, inverted, rhs)

30



Chart 41: Current net profit margins versus trend by sector Chart 42: Current EBIT margins versus trend by sector

Source: S&P Capital IQ Equity Research; 9 December, 2013 Source: S&P Capital IQ Equity Research; 9 December, 2013

Adjusting to a cross-country lens, where market composition can muddy the

water, Italy (MIB) and Spain (IBEX) rank most depressed on both EBIT and net

profit margins. Recall that, unlike Spain, Italy didn’t feast on a credit cycle. The

UK and French markets also score weakly. The export champions DAX and OMX

have a smaller discount to previous cycle margins than the SXXP but still trade

on a discount nonetheless. The Swiss and US markets stand out with modest

premiums.

Chart 43: Current net profit margins versus trend by country Chart 44: Current EBIT margins versus trend by country

Source: S&P Capital IQ Equity Research, Bloomberg; 9 December 2013 Source: S&P Capital IQ Equity Research, Bloomberg; 9 December 2013

What is consistent are the stronger profitability performances of the all mid-cap

indices versus their domestic large cap equivalents. Note that these indices are

typically less exposed to Financials.

‐140

‐120

‐100

‐80

‐60

‐40

‐20

0

20147%

Premium/Discount To 2003‐07 Net Profit Margins (%)

‐80

‐60

‐40

‐20

0

20

40

Premium/Discount To 2003‐07 EBIT Margins (%)

‐100

‐80

‐60

‐40

‐20

0

20

40

MDAX S&P 500 SMI FTSE 250 OMX DAX Stoxx 600 FTSE 100 Euro Stoxx CAC 40 CM100 IBEX FTSE MIB

Premium/Discount To 2003‐07 Net Profit Margins (%)

‐60

‐40

‐20

0

20

CM100 SMI MDAX S&P 500 FTSE 250 DAX OMX FTSE ItaliaMC

CAC 40 Stoxx 600 FTSE 100 Euro Stoxx IBEX FTSE MIB

Premium/Discount To 2003‐07 EBIT Margins (%)

31



Themes

Financials & Cyclicals We are overweight on both Banks and Insurers as well as the majority of cyclicals

over defensives, all premised on significant earnings recoveries. We caution

however that we are either marketweight or underweight on what we deem ‘old

economy’ cyclicals: Oil & Gas, Basic Resources and Chemicals.

Financial stocks have climbed steadily since late June 2012, in our view in

response to Draghi’s game-changing speech, gaining over 54% in absolute price

terms and 19% relative. EZ banks in particular have re-rated: to 0.8x tangible book

value from 0.5x. We believe there is more to go. Financials’ EPS outturns remain

35% below the SXXP since the end of 2007 (chart 45), over 50% in absolute terms,

and we expect this to close over the coming years, as highlighted in the earlier

chapters.

Cyclicals’ EPS are similarly below 2007 levels (-10%), but given the depressed

nature of SXXP earnings inclusive of Financials, they are 13% above relatively.

This outperformance was booked between 2010-11, however, and thereon both

defensives and financials have witnessed stronger relative EPS momentum.

Chart 45: Relative EPS trends by group Chart 46: Cyc/Def EPS versus EZ composite PMI

Source: S&P Capital IQ Equity Research; relative to SXXP; 9 December, 2013 Source: S&P Capital IQ Equity Research; 9 December, 2013

This may be about to reverse judging by the current PMI composite trajectory

(chart 46). The latter typically leads the cyclical/defensive EPS dynamic by three

quarters and suggests 30% earnings outperformance in that period. Current

consensus 2014E EPS growth forecasts average 21% for Cyclicals and nearly 6%

for Defensives, equating to a 15 percentage point spread. In addition, those

forecasts include some that will be difficult to attain, in our view, particularly

22.7% for Basic Resources and 13.5% for Oil & Gas. The SXXP is currently pricing

in 13.6% EPS growth in 2014, with Utilities the only sector with negative earnings

growth. Cyclical sectors are expected to deliver the greatest earnings recovery

‐40

‐30

‐20

‐10

0

10

20

30

40


Financials Rel EPS Cyclicals Rel EPS Defensives Rel EPS

%

‐60

‐40

‐20

0

20

40

60

80

100

35

40

45

50

55

60

65

Jun‐06 Jun‐08 Jun‐10 Jun‐12

EZ PMI Comp (lhs) Europe Cyc/ Def Fwd EPS (%yy, 3q lag, rhs)

Cyclicals outperform defensives

32



and all bar Media have higher growth forecasts than defensives (table 3). Drilling

down, defensives are premised on a modestly higher revenue rebound but

operating margins are less depressed than many of their cyclical peers.

In regards to prices and investor positioning, our cyclical-defensive dynamic fits

well with movements in the CESI indices (chart 47). These daily indices move in

sync with the monthly PMIs and have behaved more range-bound with the latter

in close proximity to the 50 threshold levels. We expect them to move higher in

2014. Cyclicals have re-rated modestly above their relative long-term average

levels and hence their prices are no longer depressed. Their greatest attraction

however lies in the fact that the strength of their earnings recovery will reduce

this slight over-valuation quickly in our view.

Chart 47: Cyclicals have moved in line with fundamentals Chart48: Cyc/Def valuations no longer depressed

Source: S&P Capital IQ Equity Research; 9 December 2013 Source: S&P Capital IQ Equity Research; 9 December 2013

The structure, age and competitiveness of each industry can be different and

hence they trade within different valuation ranges. Large pockets of European

equities are expensive when measured against depressed earnings but much

cheaper against book values. Hence, we recalibrate different valuation metrics

(P/E, P/B and EV/Sales) to gauge how over- or under-valued they may be via the

number of standard deviations above or below their long-term norms.

In an attempt to gain greatest clarity, sectors will have to be above or below all

three measures to be definitively classified as either expensive or cheap. In terms

of the cyclical-defensive debate, the results are neutral: Chemicals, Industrial

Goods & Services, Media and Technology are expensive, as are Food &

Beverages, Healthcare, Personal & Household Goods and Retail.

78

82

86

90

94

98

‐100

‐50

0

50

100

Jan‐12 Apr‐12 Jul‐12 Oct‐12 Jan‐13 Apr‐13 Jul‐13 Oct‐13

CESI EZ (lhs) Europe Cyc/ Def (rebased, rhs)

Cyclicals outperform defensives

0.55

0.65

0.75

0.85

0.95

Jul‐10 Jan‐11 Jul‐11 Jan‐12 Jul‐12 Jan‐13 Jul‐13

Cyclicals Forward PE rel to Defensives

Cyclicals re‐rating

Avg: 0.75

33



Table 3: Sector scorecard

Source: S&P Capital IQ Equity Research; operating leverage and valuation metrics measured between 2005-2013 ytd; 9 December, 2013

Domestic EU > US > EMs

We continue to prefer EZ domestic plays as well as US exposure but remain wary

of EM exposed names. Performance has been inconsistent throughout the

quarters of 2013: the US-exposed basket was the standout performer in Q1 as

both Domestic EU- and EM-exposed buckets posted negative returns; these

continued in Q2 for EMs and EU stocks rebounded to close the gap on the US

basket, which had plateaued, before ending the year very strongly (30.3% ytd,

Table 4). We believe that this order will be repeated in 2014.

The China basket climbed 6.5% this year and consensus forecasts are for over

20% EPS growth next year, an attractive combination for some no doubt. We are

unsure how these earnings will be achieved given the reliance on the Miners and

Mining equipment and Luxury Goods revenues weren’t depressed this year.

Instead the EZ domestic Cyclicals basket highlights many of the trends we have

discussed: most expensive P/E on depressed earnings, at 15.5x 2014E, and 1.4x

P/B 2014E being the cheapest. We are confident that these valuations will be

reduced by a growing earnings base.

EBIT Margin Improvement

Operating Leverage

EPS Revenues (y/y, bps) PE PB EV/Sales

Autos & Parts 21.5 5.3 37 -0.1 0.6 0.3 0.8Basic Resources 22.1 5.5 97 1.1 -0.9 -1.4 0.4Chemicals 12.4 2.8 89 1.6 1.7 2.1 1.1Construction & Materials 18.2 2.2 70 1.7 -0.2 -0.3 0.8Industrial Goods & Services 15.1 4.4 74 1.4 1.0 1.6 1.2Media 10.4 2.1 79 2.9 1.5 2.0 1.2Oil & Gas 13.0 0.9 99 0.6 -1.0 -1.0 0.6Travel & Leisure 31.4 3.9 98 1.0 1.6 -0.3 0.1Technology 45.5 1.4 295 2.0 0.8 1.1 0.6

21.1 3.2 104 1.4 0.6 0.5 0.8

Food & Beverages 9.3 4.7 61 1.5 0.8 1.8 1.3Healthcare 8.2 3.7 82 0.9 0.2 0.8 0.9Personal & Household Goods 11.3 6.1 64 1.1 2.0 2.1 1.5Retailers 10.0 4.8 18 1.8 1.0 0.4 1.1Telcoms -0.4 -0.3 53 1.8 1.4 -0.2 1.0Utilities -4.2 1.1 -25 0.6 -0.9 -1.3 0.7

5.7 3.4 42 1.3 0.8 0.6 1.1

DJ Stoxx 600 13.5 3.3 65 1.8 -0.1 -0.8 0.7

2014 Growth (%) Valuations (StDev Above/Below Avgs)

34



Chart 49: Long-term relative performance by key

geographies

Table 4: Fundamentals by basket

Source: S&P Capital IQ Equity Research, Bloomberg; relative to SXXP, 9 December 2013 Source: S&P Capital IQ Equity Research, Bloomberg; 9 December 2013

The superior growth impulse from EMs during the last cycle is unlikely to be

repeated. GDP growth profiles are still higher vis-à-vis developed market (DM)

economies but a strong USD environment has significant adverse implications for

both EM economies and European revenues generated from them.

Chart 50: EM currencies performance since ‘taper’

announcement

Chart 51: EM financial conditions a negative


In the same period, hard currencies uniformly appreciated against the USD: the

yen by 1.3%, euro by 4%, Swiss franc 5.4% and sterling by 6%. We believe that

these will unwind over the next 12 months but the pace will likely differ between

them. For example, we expect the euro to depreciate quicker than the cable rate.

-30

-20

-10

0

10

20

30

40

Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13

BRICs US Exposure Domestic EU

%

Theme Perf YTD (%) P/E P/B ROE Revenue Grow th (%) EPS Grow th (%)

China Exposure 6.5 14.0 1.9 10.2 4.6 20.3EZ Domestic Cycs 30.3 15.5 1.4 4.6 2.3 14.6UK Domestic 26.0 13.7 2.1 5.7 5.9 13.0US Exposure 22.1 14.7 2.2 13.6 4.0 15.9Stoxx 600 16.6 13.4 1.8 8.9 3.1 13.5

SXXP Cyclicals 17.9 13.8 2.2 13.7 3.7 16.7SXXP Defensives 16.4 15.0 2.9 17.6 3.1 5.0

MSCI Grow th 14.9 15.7 2.6 6.0 5.0 18.1MSCI Value 16.3 11.4 1.4 10.1 1.9 9.4

2014E

‐20

‐15

‐10

‐5

0

5

% Performance Since Fed Taper Announcement (May 22)

‐1.8

‐1.2

‐0.6

0

0.6

1.2

1.8

Dec‐12 Mar‐13 Jun‐13 Sep‐13

US Financial Conditions Asia ex Japan Financial Conditions EZ Financial Conditions

Tighter Financial Conditions

Easier Financial ConditionsIndex

35



Choose Value Over Growth The argument of value over growth is often blurred, in our view as different

language is used to describe the same thing. It is predominantly determined by

top-and bottom-slicing of market constituents by their ranked price-to-book

values and hence sector representation varies significantly. Continental Europe is

historically market-cap weighted towards value stocks, versus higher

representation towards growth stocks in the US. Within Europe, a preference for

growth would exclude our conviction call on Financials and invest instead in the

defensive growth subset which we believe will underperform as their elevated

valuation premiums unwind. Ergo, based on our supersector recommendations,

we favour value over growth.

Chart 52: Value more attractive when volatility ebbs Chart 53: Value typically outperforms during rising bond yields


Volatility and yield levels are primary determinants of the relative performance

between value and growth styles, as evidenced by the relationships with the

VStoxx volatility index (chart 52) and US Treasury 10-year yields (chart 53). What

is distinctive is the identical performances of the styles globally: since 2000, the

difference between US and European performances of their respective

growth/value dynamic is a solitary percentage point. Since Q2 2007, growth has

outperformed value by 31% in Europe and 26% in the US. We think this will

unwind.

An extension of this style analysis is to consider the investment position of

higher quality names, loosely determined by the strong financial flexibility of a

healthy balance sheet and consistent top-line sales momentum. These stocks

matched the peaks and troughs of the 2003-09 cycle according to our cousins in

S&P Capital IQ Alpha Factor Library (an independent division of McGraw-Hill

Financial) but have outperformed by 62% since the end of 2011. We expect this to

unwind over the coming 12 months.

0

10

20

30

40

50

60

70

0.5

0.6

0.7

0.8

Jun‐03 Jun‐05 Jun‐07 Jun‐09 Jun‐11 Jun‐13

EU Growth / Value (lhs) V2X (price, rhs)

Growth outperforms value

Ratio0

1

2

3

4

5

6

70.5

0.6

0.7

0.8

Jun‐03 Jun‐05 Jun‐07 Jun‐09 Jun‐11 Jun‐13

EU Growth / Value (lhs) UST 10Yr Yields (%, inverted, rhs)

Ratio

36



Time To Overweight The Periphery Of the major global markets, the FTSE MIB and IBOVESPA indices offer the

deepest value from a 2014E P/E to EPS growth snapshot (chart 54). A common

reaction function is question if either resemble a value trap? 2013 year-to-date

performance is a key distinction between them; Italy, up 12.5% in local terms, is

in keeping with the pack of European markets while Brazil, down 16%, is one of

the worst performers globally.

Chart 54: 2014E P/E versus EPS growth Chart 55: 2014E ROE versus P/B

Source: S&P Capital IQ Equity Research; 9 December 2013 Source: S&P Capital IQ Equity Research; 9 December 2013

National markets are more consistently priced on a ROE / Price to Book basis

(chart 55). US, Swiss and Nordic markets are more highly valued for their

profitability while the periphery markets, and French in close proximity, score

lowest.

But what is the likelihood of a ROE recovery, and does the current weakness

augur for future profits? Starting at the European-level, the SXXP exhibited ROE

levels between 14%-15% between 2006-08 before troughing around 8% during

2009. Current levels of 8.9% are consistent with the 2004 recovery and we note

that US ROE has returned to pre-2007 levels without extended bank lending.

Italian ROE levels are the weakest at 3.8% but Spanish profitability has taken the

biggest dive from an overheated pre-crisis 22% to 6.8% currently. Now, both

Italian and Spanish markets have some of the highest exposure to Financials in

the world with 31% and 33% respectively (behind China at 42%). 2013 may have

seen the beginning of rising bond yields but it has not been uniform; it has been

concentrated on previous safe havens and the more distressed sovereigns, and

corporates, have seen continued risk compression throughout the year. Italian

and Spanish spreads are still wide versus Bunds and we anticipate this to tighten

further in 2014. Under this scenario, one would expect Financials to gain an

advantage via cheaper cost of funds as well as Utilities. Recall too that the SME-

heavy, credit-constrained peripheral economies will see a trickle-down effect if

Banks have easier financial conditions. This could provide an upside lever to the

current depressed non-financial ROE 10.7% in Italy and 11.1% in Spain.

CAC 40

DAX

IBEX 35

FTSE MIB

OMX 30SMI

Euro Stoxx 50 Pr

S&P 500

NIKKEI 225

IBOVESPA

ASX 200FTSE 250

MDAX

CAC Mid 60

FTSE Italia Mid Cap

S&P 400

FTSE 100

SXXP

S&P 600

SHCOMP

7

10

13

16

19

0 10 20 30

2014 PEs

2014E EPS Growth (%)

CAC 40

DAX

IBEX 35

FTSE MIB

OMX 30

SMI

Euro Stoxx 50 Pr

S&P 500

NIKKEI 225

IBOVESPA

ASX 200FTSE 250

MDAX

CAC Mid 60

FTSE Italia Mid Cap

S&P 400

FTSE 100

SXXP

S&P 600

SHCOMP

0.5

1.5

2.5

0 5 10 15

2014E P/B

2014E ROE (%)

37



By comparison, the DAX has had far less volatile movements in ROE levels (it

also has the lowest exposure to Financials): averaging 12% during 2005-08 versus

11.2% currently. CAC40 is similarly light in Financials exposure and although less

cyclical than the DAX, exhibited a higher 2005-08 ROE profile of 18% before

trending down to 9.2% presently. For most ease of comparison, we can group the

markets into regional baskets of Core (CAC, DAX), Northern (FTSE100, SMI, OMX)

and Periphery (MIB, IBEX). Now we can clearly see that Core ROE levels are more

consistent and less disturbed; Northern and Periphery markets had similar ROE

profiles leading up to the Great Recession but it is the Periphery that is clearly

distressed now (chart 56).

Chart 56: ROE evolution of Core, Northern and Periphery Chart 57: Peripheral margins deteriorated post EZ sovereign

crisis, not Great Recession

Source: S&P Capital IQ Equity Research; 10 December, 2013. Core = CAC and DAX; Northern = FTSE100, SMI, OMX; Periphery = FTSEMIB, IBEX.

Source: S&P Capital IQ Equity Research; 9 December, 2013

Another distinctive feature has been the differing timelines of net and operating

profit margins. Government measures for Banks to improve the quality of their

balance sheets, via the implementation of Royal Decrees and introduction of

SAREB (the ‘bad bank’) led to a more expedient downturn in ROE levels in Spain

and, to a lesser extent, Italy. Operating margins, more representative of the

broader market and before any exceptional items are included, maintained their

strong profile until the middle of 2011 when they fell by more than a third (chart

57). Hence the Eurozone sovereign crisis offers the greater explanation to the

peripheral equity underperformance and we can safely assume that the worst of

that crisis is behind us.

2

6

10

14

18

22

Jun-05 Jun-07 Jun-09 Jun-11 Jun-13

Core Northern Periphery

%

5.0

10.0

15.0

20.0



%

38



Chart 58: Periphery Still Adrift Other EU Equities (rebased) Chart 59: Peripheral Govt Spreads Likely To Tighten Further

Source: S&P Capital IQ Equity Research; 9 December, 2013 Source: S&P Capital IQ Equity Research; spreads versus 10year Bunds; 9 December, 2013

Recent peripheral equity performance has been strong, up 21% in H2 thus far, but

don’t let that leave the impression that an opportunity has been missed.

Peripheral markets are only 25% above their Q1 2009 lows; the equivalent returns

for Core and Northern markets are 92% and 79% respectively. Equity risk premia

remain high for global equities and their likely compression will provide a

support vis-à-vis other asset classes. This is most pronounced in the Periphery;

for example, government spreads are still 80 bps above pre-EZ sovereign

crisis/post Great Recession levels (chart 59).

The IBEX and FTSE MIB have moved in lock-step over the past four years. Within

Spanish equities, cyclicals remain depressed and have failed to outperform

defensives that would be consistent with cyclical improvements in the economy

(chart 60). Government bond yields of 4.1% have typically translated into Spanish

financials trading at 2.3x book value. Those valuations may be both punchy and

premature given the issues of asset quality and ECB dependence but current book

values of only 1.1x are pricing in an awful lot of bad news.

Chart 60: Spanish cyclicals have catch-up potential Chart 61: As do Spanish financials

Source: S&P Capital IQ Equity Research, Markit; 9 December, 2013 Source: S&P Capital IQ Equity Research; 9 December, 2013

40

60

80

100

120

140

160

180

200



Price (rebased)

0

100

200

300

400

500

600


Italy Spain

Spreads

37

39

41

43

45

47

49

51

53

0.6

0.7

0.8

0.9

1.0

1.1

Jan‐10 Jul‐10 Jan‐11 Jul‐11 Jan‐12 Jul‐12 Jan‐13 Jul‐13

Cyclicals/Defensives: Perf (lhs) PMI Spain Composite (rhs)

Ratio

2

3

4

5

6

7

80.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5


Financials P/B (lhs) 10yr Govt Yields (%, inverted, rhs)

39



Sectors

Current Consensus Forecasts One of the underlying themes of this outlook is addressing depressed earnings

with discounted book values. On 2014 earnings basis, Food & Beverages and

Telecoms appear most expensive with Autos & Parts, Banks, Oil & Gas and Basic

Resources the cheapest. Interestingly, irrelevant of their cyclical or defensive

profile, many supersectors are clustered together (including Healthcare, Industrial

Goods & Services and Retailers, circled in chart 62). All of this group bar

Industrials Goods and Services are more expensive than the SXXP but offer less

earnings growth.

Technology stands out as the most expensive supersector on a price-to-book

basis (chart 63), with most fairly valued when measured against 2014 return on

equity forecasts. Greatest value opportunities appear to be in Autos & Parts,

Banks and Insurers, Basic Resources, Oil & Gas and Utilities.

Chart 62: 2014E P/E versus EPS Growth Chart 63: 2014E ROE versus P/B


Most Preferred We retain our positive view that Automobile & Parts will be a direct beneficiary of

the domestic European growth impulse and its current sector outperformance has

further room to grow. It has high operational leverage versus peers, is a more

profitable industry than in previous cycles encapsulated by greater production

harmonisation between product ranges and spurred on a very strong euro in the

past cycle. Our view of future EURUSD weakness will provide an accelerator to

the sector’s EPS profile. Car production levels are less than half of 2003 levels in

France and Italy, partly because of the structural overcapacity issues within

Europe but also due to the depressed household sector. The mass market OEMs

have greatest exposure in these weaker markets but they too appear to have

found a bottom in profits as November adjusted sales figures were reasonable in

Basic Res

RetailersMedia

F&B

Insurers

Fin Svs ChemConst & Mats

Pers & HHGs

Oil & Gas

Ind G&ST&LHealthcare

Telcos

Autos

SXXP

7

10

13

16

0 10 20 30

2014 PEs

2014E EPS Growth (%)

Tech: 18.7x, 183%

Banks: 11x, 76%

Basic Res

Retailers

Media

F&B

Banks

Insurers

Fin Svs

Chem

Const & Mats

Pers & HHGs

Oil & Gas

Ind G&S

T&L

Healthcare

Tech

Util

Telcos

Autos

SXXP

0.8

1.8

2.8

0 10 20 30

2014E P/B

2014E ROE (%)

40



Italy, France and Spain. The premium OEMs, which have lagged for large parts of

the year in share price terms, are gathering sales momentum with management

looking to reduce the normal fortnight plant closures over the Christmas period.

Chart 64: Returning consumer confidence driving auto sales Chart 65: Car production levels (% from 2003 levels)

Source: S&P Capital IQ Equity Research; 9 December, 2013 Source: S&P Capital IQ Equity Research, OICA; 9 December, 2013

Media continues to invest more heavily towards digitalisation, resulting in an

incrementally higher ROE profile. With global GDP growth accelerating in 2014,

and likely to be upgraded in our view, current consensus EPS growth forecasts of

10% look low. We favour the agencies and broadcasters of the more defensive

publishers.

Total advertising revenues are between -1% and 2% from their 2007 levels in the

big economies of France, Germany and UK but are a staggering 19% and 42%

below in Italy and Spain respectively. Magnaglobal forecasts that annual growth

in total advertising revenues in North America will accelerate from 0.7% at the

end of 2013 to 5.6% one year out and swing from -0.1% to 2.5% in Europe. Given

the sensitivities to the economic cycle, we believe the current global forecast of

4.5% will be revised up.

Chart 66: Ad agencies superior EPS profile (rebased) Chart 67: Media is 2x geared into GDP cycle

Source: S&P Capital IQ Equity Research; 9 December, 2013 Source: S&P Capital IQ Equity Research, Magnaglobal; 9 December, 2013

‐30

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‐10

0

10

20

30

‐40

‐30

‐20

‐10

0

10


EU Consumer Confidence (lhs) EU New Car Registrations (%yy, rhs)

‐70

‐60

‐50

‐40

‐30

‐20

‐10

0

10

Germany US UK Spain France Italy

Car Production Levels (% from 2003)

80

90

100

110

120

Dec-11 Jun-12 Dec-12 Jun-13

Broadcasters Ad Agencies Publishers

‐15

‐10

‐5

0

5

10

15

‐6

‐3

0

3

6

Dec‐99 Dec‐01 Dec‐03 Dec‐05 Dec‐07 Dec‐09 Dec‐11 Dec‐13

Global GDP Growth (%y/y, lhs) Global Advertising Spend (%y/y, rhs)

41



We upgrade Construction & Materials to overweight from marketweight on the

combination of a visible EPS recovery and still attractive valuations. The sector is

highly geared into a domestic European recovery and has high operational

leverage. European construction confidence has rebounded impressively in H2

2013 and is now at a five-year high, against production levels 23% below the pre-

crisis peak. Similarly, forward EPS are 44% below such levels but we expect this

to narrow as consensus estimates get upgraded (chart 68). Price to book values

of 1.6x is comfortably below the long-term average and can be expected to re-

rate above during a fully-fledged recovery.

Chart 68: Construction & Materials EPS Recovery Chart 69: Construction & Materials P/B Below LT Average

Source: S&P Capital IQ Equity Research, Bloomberg; 9 December, 2013 Source: S&P Capital IQ Equity Research, Bloomberg; 9 December, 2013

Weakness in Basic Resources prices have reflected their overexposure to China.

The recently announced reforms are viewed as positive and hence reduce our

fears of a significant Chinese slowdown and higher volatility. The caveat however

is that structural reforms take longer to feed through than cyclical government

measures and Basic Resources remain exposed in the interim.

Industrial metals typically have an inverse relationship with USD and our

expectations of a secular USD bull run will be a significant headwind: Basic

Resources share prices have had a 79% correlation with the copper price over the

past 24 months. It will be challenging for the copper price given current LME

inventories are elevated at over 411,000 metric tonnes. To put this in context,

these inventories were 48,875 tonnes at the beginning of the last cycle in 2004.

‐50

‐40

‐30

‐20

‐10

0

10

20

30

‐45

‐40

‐35

‐30

‐25

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Oct‐08 Oct‐09 Oct‐10 Oct‐11 Oct‐12 Oct‐13

EU Construction Confidence (lhs) Construction & Materials EPS (%yy, rhs)

0.0

1.0

2.0

3.0

Jan-03 Jan-05 Jan-07 Jan-09 Jan-11 Jan-13

SXOP Fwd Price To Book

42



Chart 70: Copper inventories approaching multi-year highs Chart 71: Strong USD cycle a headwind for industrial metals

Source: S&P Capital IQ Equity Research, LME, Bloomberg; 9 December, 2013 Source: S&P Capital IQ Equity Research, CRB, Bloomberg; 9 December, 2013

We anticipate a material upturn in gross fixed capital formation in both Europe

and the US in 2014, as previously outlined. Our overweight position on Industrial

Goods & Services captures this but recent relative performance trends do not.

The sector is not cheap, as the sector scorecard showed it is above last cycle’s

short-term and longer-term valuation metrics. However, these have only adjusted

to the greater cost discipline and hence higher profitability profile. We continue

to favour the secular growth story in commercial aerospace as well as industrial

conglomerates and professional services.

Chart 72: Industrials ‘priced for imperfection’ Chart 73: ROE profile has shifted higher


0

200,000

400,000

600,000

800,000

1,000,000

Dec-95 Dec-98 Dec-01 Dec-04 Dec-07 Dec-10 Dec-13

LME Warehouse Copper Stocks (inverted, tonnes, rhs)

June: 665k

65

75

85

95300

500

700

900

1100

Dec-05 Dec-08 Dec-11

CRB Metals (lhs) DXY Index (inverted, rhs)

USD Strengthening

‐20

‐15

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‐5

0

5

10

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0

10

20

30


SXNP Rel Perf (6m lead, %yy, lhs) EZ GFCF Growth (%y/y, rhs)

10

12

14

16

18

20

22

Mar-09 Mar-10 Mar-11 Mar-12 Mar-13

Industrial Goods & Services ROE

%

43



Healthcare remains our preferred defensive sector. The structural issues of the

patent cycle are now behind us and our analysts as most confident about the

pipeline of large-cap pharma for many years, particularly Phase two. From a

higher level, the US remains the largest market and hence USD sensitivity is

significant (chart 75). Our expectations for a multi-year appreciation of the

USDEUR rate, signalled by the Fed’s announcement on tapering their asset

purchases, should aid sector outperformance. Additionally, while the sector will

underperform in the early recovery stages, we estimate that it tends to catch up

once the ISM Manufacturing New Orders have peaked. November’s reading of

60.6 is in peak territory in our view.

Chart 74: Peak in ISM Manufacturing New Orders Typically

A Positive

Chart 75: Healthcare would benefit from a strong USD cycle


Travel & Leisure continues to exhibit a superior earnings profile in relation to the

SXXP. The sector composition ranges from gambling to recreational activities but

the two key drivers, airlines and hotels, both have the potential to see EPS

upgrades in 2014. Airlines will be a direct beneficiary of our expectations for

weak oil prices while revenue per room trends should improve on the

combination of higher business and household expenditure.

Chart 76: T&L relative EPS momentum impressive (rebased) Chart 77: Airlines benefit from weak oil prices


-50

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0

25

5020

30

40

50

60

70

Jan-02 Jan-04 Jan-06 Jan-08 Jan-10 Jan-12

US ISM Mfg New Orders (lhs) Healthcare Rel Perf (%yy, inverted, rhs)

-50

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30


USD TWI (%yy, lhs) Healthcare Rel Perf (%yy, rhs)

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120



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WTI (%12m, inverted, lhs) Airlines Rel Perf (%12m, rhs)

44



Software and services has been the most consistent industry within Technology

in terms of relative earnings and price momentum as hardware faced structural

headwinds and semiconductors, by its nature, is very short-cycle. However, all

three groups are in the middle of an upturn and hence the current strength in

relative earnings momentum is broad-based. The Federal Reserve San Francisco

Technology Pulse index, designed to capture enterprise spending, suggests that

the sector has significant positive earnings revisions in the coming quarters.

Chart 78: Technology EPS upgrades look likely Chart 79: Relative EPS momentum recovered from weak H2 12

(rebased)


Finally, we close our underweight on Chemicals. The sector is still seeing weak

pricing power, according to the IFO, but it is difficult to see this position

deteriorate further and hence should offer support to share prices. Chemicals are

economically sensitive to the cycle, usually 1.25x geared, therefore we anticipate

a volume recovery. The IFO Chemicals business climate typically leads EPS

movements by two quarters and points towards mid-teen earnings growth as we

progress through 2014 – slightly above the current consensus of 12%. We are

marketweight due to the absence of an improving pricing environment coupled

with valuation levels that are consistent with a strong EM rebound (the sector has

an above-average exposure) that we cannot see materialising. We advise select

stock-picking.

10

12

14

16

18

20

22

24

60

70

80

90

100

Feb‐05 Feb‐07 Feb‐09 Feb‐11 Feb‐13

FRB San Francisco Tech Pulse Index (lhs) SX8P FY2 EPS (EUR, rhs)

76

88

100

112



45



Chart 80: Chemicals weak pricing power continues Chart 81: But improving volumes should drive EPS upgrades

Source: S&P Capital IQ Equity Research, Bloomberg, IFO Institute; 9 December, 2013 Source: S&P Capital IQ Equity Research, IFO,Bloomberg; 9 December, 2013

Least Preferred

We remain out of favour with Food & Beverages as we view the unwinding of

premium valuations as a multi-year phenomenon. This became particularly

relevant for the Food & Beverage sector as relative earnings momentum

deteriorated and it no longer justified its ‘defensive growth’ top billing. Organic

earnings trends have plateaued in line with weak soft commodity prices and any

rebound here would still lag the broader market in our view. Typically the sector

underperforms in a rising bond yield environment and there is no reason to

expect it will be any different this time round.

Chart 82: Food & Bev EPS Growth Flat.. Chart 83: …And Likely To Underperform During Rising Yields


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IFO Chemicals: Prices IFO Chemicals: Price Expectations

Index

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Nov‐06 Nov‐08 Nov‐10 Nov‐12

IFO Chemicals: Bus‐Climate (index, 6m lead, lhs) Chemical EPS (%y/y, rhs)

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Mar‐09 Mar‐10 Mar‐11 Mar‐12 Mar‐13

SX3P: 12m Fwd EPS (yy, lhs) Agricultural Commodity Inflation (%yy, rhs)

0

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6

8‐50

0

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100

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200

Jan‐00 Jan‐02 Jan‐04 Jan‐06 Jan‐08 Jan‐10 Jan‐12

Food & Bev Rel Perf (%, lhs) UST 10yr Yields (%,inverted, rhs)

46



We downgrade Personal & Household Goods to marketweight. Similar to its

‘defensive growth’ cousin Food & Beverages, the ‘higher quality’ nature has

pushed sector into premium valuations that we believe will unwind as cyclical

tailwinds improve for other sectors. Relative earnings momentum has decoupled

in 2013 however; Food & Beverage has slowed materially to -0.3% y-o-y in

absolute terms versus Personal & Household Goods’ 5.7% y-o-y. Hence we keep

Personal & Household Goods at marketweight.

Chart 84: Defensive growth cousins decoupling (rebased) Chart 85: Luxury goods P/B needs to unwind

Source: S&P Capital IQ Equity Research, Bloomberg; relative to SXXP, 10 December, 2013 Source: S&P Capital IQ Equity Research, Bloomberg; 10 December, 2013

We are underweight on Oil & Gas since February for two reasons: we expected

free cash flow to decline across the sector as the major IOCs embark on a multi-

year investment cycle, and a perceived ceiling on Brent oil prices. In reality, Brent

has been range bound since, around USD100-USD115. Free cash flow has

declined however, to –EUR4.7 bln for FY/13 estimates, from EUR119 bln in Q2

2010, as capex has increased 7% y-o-y and is expected to do the same in FY/14.

Oil demand should incrementally improve but not enough to overcome the

supply dynamic; Saudi Arabian exports are at their highest since 2005, while US

production has been growing 10% y-o-y. SXEP forward EPS are hugely influenced

by the annual change in Brent (chart 50) and hence it is difficult to see where the

FY14 consensus growth of 13.5% and 100 bps of operating margin improvement

will come from. Thus, we expect consensus downgrades and short the sector.

‐10

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20

30

40

50

60

Jan‐10 Jan‐11 Jan‐12 Jan‐13

Pers & HH Gds Rel Earnings Pers & HH Gds Rel Perf Food & Bev Rel EPS Food & Bev Rel Perf

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80

1.0

2.0

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Oct-04 Oct-06 Oct-08 Oct-10 Oct-12

Luxury Goods P/B (lhs) Hong Kong Retail Sales: Jewelry, Watches & Clocks (%y/y, vol, rhs)

47



Chart 86: Oil & Gas EPS heavily influenced by Brent rrice Chart 87: While free cash flow burns

Source: S&P Capital IQ Equity Research; 9 December, 2013 Source: S&P Capital IQ Equity Research, Bloomberg; 9 December, 2013

Telcos have re-rated strongly during H2 2013, driven by multiple M&A

considerations in our view. Our Telcos analysts are cautious on any further M&A

support based on limited potential cost and revenue synergies, regulatory

pressure and strained balance sheets of any acquired names.

Otherwise, the sector typically performs poorly in a rising bond yield

environment and, due to the exceptional recent outperformance, now appears

vulnerable.

Chart 88: Telcos underperform during rising bond yields Chart 89: Recent relative performance pricing in questionable

EPS relative rebound (rebased)


2

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Jan-08 Jan-10 Jan-12

WTI Oil (USD, lhs) Oil & Gas FY2 Fwd EPS (EUR, rhs)

-

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120,000

140,000

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0

4,000

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Mar-09 Mar-11 Mar-13

E&P Oil Services Integrated (rhs)

EUR (mln) EUR (mln)

-2

-1.5

-1

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0

0.5

1

1.5-50

0

50

Jul-09 Jul-10 Jul-11 Jul-12 Jul-13

EU Telcos Rel Perf (%6m, lhs) EU Bond Yields (6m chng, inverted)

r: ‐0.52

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0

10

Jan‐10 Jan‐11 Jan‐12 Jan‐13

Price Rel Earnings FY2 Rel

48



Utilities remain a structurally challenged sector. Current consensus EPS forecasts

total 1% cumulative growth from here through to 2015. Power prices, both base

and peak, remain depressed across Europe and show little sign of an immediate

change of fortune. Overcapacity in most countries, bar the UK perhaps, leaves

profitability strained: dark spreads, the gross margin on coal power production,

has recovered some of their 2013 decline in recent months but clean spark

spreads (gas-fired plants) continue to fall, most notably in France and Germany.

Chart 90: Utilities relative performance by business model Chart 91: Clean spark spreads by country


-60

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0

20

40

Dec-09 Jun-10 Dec-10 Jun-11 Dec-11 Jun-12 Dec-12 Jun-13

Generators / Renewables Rel Integrated Rel Perf Regulated Rel Perf

%

‐24

‐18

‐12

‐6

0

6

12

18

24

Jan‐12 Jul‐12 Jan‐13 Jul‐13

Spain Germany UK France Italy

EUR, mwh

49



Thoughts On Other Asset Classes

Our optimism on European equities is fundamentally grounded. When viewed

against other asset classes, the investment case is even more compelling.

European equity dividend yields have been above both investment grade (IG) and

sovereign yields for some time now. The run in IG bonds, in both Europe and the

US, ended in Q4 2012 and total returns have been flat to negative since (chart 92).

European high yield has continued to perform strongly, mirroring developments

in the SXXP meanwhile. It is difficult to expect this to be matched in 2014 as

yields of 3.5% on European crossover bonds must assume extremely favourable

default rates to remain attractive. The 10-year average yield of 5.5% is 200 bps

higher than current levels; the US has a similar dynamic, being 100 bps adrift. We

expect HY bond prices to fall during 2014.

Chart 92: European high yield outperformed IG in 2013, will

struggle to match equities in 2014

Chart 93: Crossover 10-year bond yields at multi-decade lows

Source: S&P Capital IQ Equity Research, iBoxx; 9 December, 2013 Source: S&P Capital IQ Equity Research, Bloomberg; 9 December, 2013

The US economy is more advanced in its recovery versus Europe and is set to

accelerate back to, and potentially above, trend growth rates in 2014. The broad-

based nature of the recovery and the closing of the ‘twin deficits’ of the pervious

cycle leads us to believe that the USD is entering a new secular bull run. In fact,

this has already started against soft currencies but has been delayed by the QE

policies of the hard currency nations. The Federal Reserve will lead other central

banks in quantitative tightening and this belief underpins our strong USD outlook.

Underlying commodities are heavily inverse-related to USD movements. In this

regard, we expect commodity inflation to be sub-par in the coming years –

boosting consumer facing sectors ahead of the industrial producers.

80

100

120

140

160

180

200

220

240


US IG EU IG EU HY SXXP (TR)

2

4

6

8

Oct‐02 Oct‐04 Oct‐06 Oct‐08 Oct‐10 Oct‐12

US BAA Corporate Yield (%) Europe BBB Corporate Yield (%)

50



Chart 94: Gold price inversely related to USD TWI Chart 95: Commodities perf versus USD cycles


The last USD down cycle (group four in chart 95) coincided with the Chinese

supercycle and witnessed enormous commodity inflation across oil, copper, iron

ore and precious metals such as gold. The absence of the same Chinese growth

impetus alongside a stronger USD leaves each of these exposed to downside rise,

which is what we expect.

We would like to take this moment to wish all of our clients a very Merry

Christmas and a prosperous 2014.

65

67

69

71

73

75

77

79

1200

1400

1600

1800

2000

Aug‐11 Feb‐12 Aug‐12 Feb‐13 Aug‐13

Gold Price (USD, lhs) TWI US$ (inverted, rhs)

‐50

0

50

100

150

200

250

1. 2. 3. 4.Crude Oil Copper Iron Ore Gold USD TWI

%

51



Index Targets

Given our multi-year positive outlook on the SXXP and the early stage of the

cycle, we anticipate absolute gains across all of the other main European indices.

Our bullish forecast of 21.9% total return on the SXXP is sandwiched between the

FTSE (13.6%) and the MIB (24.6%)

Table 5: National index price targets

Source: S&P Capital IQ Equity Research estimates, Bloomberg; 9 December, 2013

Our sector-adjusted approach is simplistic but supported by our covered

fundamental analysis (for example, the strongest macro rebound in the

periphery) and weakest sector composition (Miners will weigh on the FTSE, which

typically underperforms in rising markets). Both the FTSE MIB and IBEX are

heavily weighted towards Financials: 31% and 33% respectively, versus 21% for

the SXXP. In addition, the FTSE MIB has a particularly cyclical/defensive

overweight.

Current Price End-2014 Target Price DY 14 % Total Return2014E 2015E

CAC 4,129 4,750 11.7 11.5 3.6 18.6 DAX 9,172 10,700 10.3 12.5 2.9 19.5 IBEX 9,401 11,200 19.3 17.6 5.1 24.3 MIB 18,124 22,000 30.4 22.2 3.2 24.6 OMX 1,275 1,450 13.0 11.7 3.9 17.6 UKX 6,552 7,200 10.2 8.9 3.7 13.6

SXXP 317 375 13.5 12.0 3.4 21.9

% EPS Grow th

52



Appendix - Preferred Stocks

We have filtered our coverage for Buys, Strong Buys and Holds that satisfy some

of the themes highlighted in this report and list them below.

Table 6: Preferred Stocks for 2014

Source: S&P Capital IQ Equity Research estimates ; 10 December, 2013

Ticker Recommendation Target Price Current Price % Upside DY %, 13

Cyclicals:

Accor AC FP Buy 38 33 15.3 2.3

ACS ACS SM Hold 26 23 15.6 2.8

Adidas AG ADS GY Buy 98 88 11.7 1.5

ARM Holdings ARM LN Hold 1,100 1,011 8.8 0.5

ASML Holding ASML NA Buy 80 67 19.2 0.9

Carnival Plc CCL LN Strong Buy 2,700 2,149 25.6 3.3

CRH PLC CRH ID Hold 20 18 13.8 3.6

Daimler AG DAI GY Buy 64 60 7.3 3.4

Dassault Systèmes DSY FP Buy 100 85 17.2 0.9

EADS EAD FP Strong Buy 60 50 18.8 1.7

Ericsson ERICB SS Buy 90 80 12.5 3.4

Ferrovial SA FER SM Buy 15 14 7.5 5.1

Hermes International RMS FP Buy 290 251 15.6 1.0

Deutsche Lufthansa LHA GY Buy 17 15 10.7 2.0

Fraport FRA GY Buy 62 54 14.6 2.3

GEA Group G1A GY Buy 36 33 8.3 2.0

Heidelberg Cement HEI GY Buy 63 54 17.4 3.0

Inditex ITX SM Buy 130 116 12.1 2.1

ITV Plc ITV LN Buy 200 184 8.9 1.7

Mediaset MS IM Hold 4 3 21.3 0.0

Philips Electronics PHIA NA Buy 29 25 12.7 3.0

Publicis PUB FP Hold 66 64 3.1 1.6

Repsol REP SM Buy 21 18 14.9 5.3

Rolls-Royce Group Plc RR/ LN Buy 1,400 1,206 16.1 1.7

Royal Caribbean Cruises RCL NO Strong Buy 315 269 17.2 0.9

Saint-Gobain SGO FP Buy 42 37 13.8 3.5

WPP Group WPP LN Buy 1,500 1,318 13.8 2.5

Defensives:

Beiersdorf AG BEI GY Strong Buy 82 74 10.2 1.1

Danone BN FP Buy 60 52 14.9 3.0

Diageo DGE LN Buy 2,270 1,925 17.9 2.6

Novo Nordisk NOVOB DC Buy 1,100 975 12.8 2.2

Roche Holdings ROG VX Buy 288 243 18.5 3.3

SSE plc SSE LN Buy 1,500 1,300 15.4 6.0

Sanofi SAN FP Buy 86 74 16.8 3.5

Shire SHP LN Buy 3,200 2,731 17.2 0.4

Financials:

Axa CS FP Buy 20 18 5.7 5.3

BNP Paribas BNP FP Buy 60 53 12.4 3.4

BBVA BBVA SM Hold 9 8 6.2 3.9

Julius Baer BAER VX Buy 46 42 9.5 1.5

Barclays BARC LN Buy 320 266 20.4 2.4

Intesa Sanpaolo ISP IM Hold 2 2 2.9 2.9

Nordea NDA SS Buy 88 83 5.5 4.3

Societe Generale GLE FP Buy 47 41 15.6 2.1

Unicredit Group UCG IM Hold 6 5 5.7 1.7

53



S&P Capital IQ European Equity Research

Roger Hirst

Director of European Equity Research

+44 (0)20 7176 7405

Consumer

Carl Short

Consumer Staples +44 (0)20 7176 8320

William Mack, CFA

Consumer Discretionary +44 (0)20 7176 8314

Alex Wisch

Media, Telecoms +44 (0)20 7176 7832

Financials

William Howlett, CFA

Banks +44 (0)20 7176 7630

Roderick Wallace, CFA

Insurance +44 (0)20 7176 7208

Health Care & Pharmaceuticals

Sho Matsubara

Pharmaceuticals +44 (0)20 7176 7831

Jacob Thrane

Health Care & Chemicals +44 (0)20 7176 7826

Industrials

Roderick Bridge

Automotive & Automotive Suppliers +44 (0)20 7176 3846

Unai Franco

Capital Goods, Aerospace & Defense +44 (0)20 7176 7851

Jawahar Hingorani

Construction +44 (0)20 7176 7847

Johnson Imode

Materials, Metals & Mining +44 (0)20 7176 7824

Energy

Christine Tiscareno

Oil & Gas +44 (0)20 7176 7838

Information Technology

James Crawshaw, CFA

IT, Telecoms Services +44 (0)20 7176 7829

Utilities & Support Services

Clive Roberts

Utilities & Support Services +44 (0)20 7176 7853

Strategy

Robert Quinn, CFA

Chief European Equity Strategist +44 (0)20 7176 7843

54


December 10, 2013

Glossary S&P Capital IQ STARS

Since January 1, 1987, S&P Capital IQ Equity Research has ranked a universe of U.S.

common stocks, ADRs (American Depositary Receipts), and ADSs (American

Depositary Shares) based on a given equity’s potential for future performance.

Similarly, S&P Capital IQ Equity Research has ranked Asian and European equities

since June 30, 2002. Under proprietary STARS (STock Appreciation Ranking System),

S&P Capital IQ equity analysts rank equities according to their individual forecast of

an equity’s future total return potential versus the expected total return of a relevant

benchmark (e.g., a regional index (S&P Asia 50 Index, S&P Europe 350® Index or

S&P 500® Index)), based on a 12-month time horizon. STARS was designed to meet

the needs of investors looking to put their investment decisions in perspective. Data

used to assist in determining the STARS ranking may be the result of the analyst’s

own models as well as internal proprietary models resulting from dynamic data

inputs.

S&P Capital IQ Quality Ranking

(also known as S&P Capital IQ Earnings & Dividend Rankings) - Growth and

stability of earnings and dividends are deemed key elements in establishing S&P

Capital IQ’s earnings and dividend rankings for common stocks, which are designed

to capsulize the nature of this record in a single symbol. It should be noted, however,

that the process also takes into consideration certain adjustments and modifications

deemed desirable in establishing such rankings. The final score for each stock is

measured against a scoring matrix determined by analysis of the scores of a large

and representative sample of stocks. The range of scores in the array of this sample

has been aligned with the following ladder of rankings:

A+ Highest B- Lower

A High C Lowest

A- Above Average D In Reorganization

B+ Average NR Not Ranked

B Below Average

S&P Capital IQ EPS Estimates – S&P Capital IQ earnings per share (EPS) estimates

reflect analyst projections of future EPS from continuing operations, and generally

exclude various items that are viewed as special, non-recurring, or extraordinary.

Also, S&P Capital IQ EPS estimates reflect either forecasts of S&P Capital IQ equity

analysts; or, the consensus (average) EPS estimate, which are independently

compiled by Capital IQ, a data provider to S&P Capital IQ Equity Research. Among

the items typically excluded from EPS estimates are asset sale gains; impairment,

restructuring or merger-related charges; legal and insurance settlements; in process

research and development expenses; gains or losses on the extinguishment of debt;

the cumulative effect of accounting changes; and earnings related to operations that

have been classified by the company as discontinued. The inclusion of some items,

such as stock option expense and recurring types of other charges, may vary, and

depend on such factors as industry practice, analyst judgment, and the extent to

which some types of data is disclosed by companies.

S&P Capital IQ Core Earnings – S&P Capital IQ Core Earnings is a uniform

methodology for adjusting operating earnings by focusing on a company’s after-tax

earnings generated from its principal businesses. Included in the S&P Capital IQ

definition are employee stock option grant expenses, pension costs, restructuring

charges from ongoing operations, write-downs of depreciable or amortizable

operating assets, purchased research and development, M&A related expenses and

unrealized gains/losses from hedging activities. Excluded from the definition are

pension gains, impairment of goodwill charges, gains or losses from asset sales,

reversal of prior-year charges and provision from litigation or insurance settlements.

S&P Capital IQ 12 Month Target Price – The S&P Capital IQ equity analyst’s

projection of the market price a given security will command 12 months hence, based

on a combination of intrinsic, relative, and private market valuation metrics, including

S&P Capital IQ Fair Value.

S&P Capital IQ Equity Research – S&P Capital IQ Equity Research U.S. includes

Standard & Poor’s Investment Advisory Services LLC; Standard & Poor’s Equity

Research Services Europe includes McGraw-Hill Financial Research Europe Limited

trading as S&P Capital IQ; Standard & Poor’s Equity Research Services Asia includes:

McGraw-Hill Financial Singapore Pte. Limited, Standard & Poor’s Investment

Advisory Services (HK) Limited, Standard & Poor’s Malaysia Sdn Bhd, and Standard

& Poor’s Information Services (Australia) Pty Ltd.

Abbreviations Used in S&P Capital IQ Equity Research Reports

CAGR- Compound Annual Growth Rate

CAPEX- Capital Expenditures

CY- Calendar Year

DCF- Discounted Cash Flow

DDM– Dividend Discount Model

EBIT- Earnings Before Interest and Taxes

EBITDA- Earnings Before Interest, Taxes, Depreciation and Amortization

EPS- Earnings Per Share

EV- Enterprise Value

FCF- Free Cash Flow

FFO- Funds From Operations

FY- Fiscal Year

P/E- Price/Earnings

P/NAV– Price to Net Asset Value

PEG Ratio- P/E-to-Growth Ratio

PV- Present Value

R&D- Research & Development

ROCE- Return on Capital Employed

ROE- Return on Equity

ROI- Return on Investment

ROIC- Return on Invested Capital

ROA- Return on Assets

SG&A- Selling, General & Administrative Expenses

SOTP- Sum-Of-The-Parts

WACC- Weighted Average Cost of Capital

Dividends on American Depository Receipts (ADRs) and American Depository

Shares (ADSs) are net of taxes (paid in the country of origin)

S&P Capital IQ Qualitative Risk Assessment – Reflects an S&P Capital IQ equity

analyst's view of a given company's operational risk, or the risk of a firm's ability to

continue as an ongoing concern. The S&P Capital IQ Qualitative Risk Assessment is

a relative ranking to the S&P U.S. STARS universe, and should be reflective of risk

factors related to a company's operations, as opposed to risk and volatility

measures associated with share prices. For an ETF this reflects on a capitalization-

weighted basis, the average qualitative risk assessment assigned to holdings of the

fund.

STARS Ranking system and definition:

5-STARS (Strong Buy):

Total return is expected to outperform the total return of a relevant benchmark, by

a wide margin over the coming 12 months, with shares rising in price on an

absolute basis.

4-STARS (Buy):

Total return is expected to outperform the total return of a relevant benchmark over

the coming 12 months, with shares rising in price on an absolute basis.

3-STARS (Hold):

Total return is expected to closely approximate the total return of a relevant

benchmark over the coming 12 months, with shares generally rising in price on an

absolute basis.

2-STARS (Sell):

Total return is expected to underperform the total return of a relevant benchmark

over the coming 12 months, and the share price not anticipated to show a gain.

1-STAR (Strong Sell):

Total return is expected to underperform the total return of a relevant benchmark

by a wide margin over the coming 12 months, with shares falling in price on an

absolute basis.

Relevant benchmarks:

In North America, the relevant benchmark is the S&P 500 Index, in Europe and in

Asia, the relevant benchmarks are the S&P Europe 350 Index and the S&P Asia 50

Index, respectively.

Disclosures/Disclaimers

Required Disclosures S&P Capital IQ ranks stocks in accordance with the following ranking

methodologies:

STARS Stock Reports: S&P Capital IQ’s qualitative STARS recommendations are

determined and assigned by S&P Capital IQ equity analysts. For reports containing

STARS recommendations refer to the Glossary section of this report for detailed

methodology and the definition of STARS rankings.

Quantitative Stock Reports: S&P Capital IQ’s quantitative evaluations are derived

from S&P Capital IQ’s proprietary Fair Value quantitative ranking model. The Fair

Value Ranking methodology is a relative ranking methodology. As a quantitative

model, Fair Value relies on history and consensus estimates and does not introduce

an element of subjectivity.

Some Quantitative Stock Reports contain Buy, Hold and Sell recommendations.

Reports that do not contain a recommendation may or may not contain ranking

information. For reports containing a recommendation or ranking information refer

to the Glossary Section of this report for more information, including a detailed

description of the methodology and definition of S&P Quality Ranking and S&P Fair

Value Rank.

STARS Stock Reports and Quantitative Stock Reports:

The methodologies used in Stock Reports and Quantitative Stock Reports

(collectively, the “Research Reports”) reflect different criteria, assumptions and

analytical methods and may have differing recommendations.

S&P Capital IQ believes that the methodologies and data used to generate the

different types of Research Reports are reasonable and appropriate. Generally, S&P

55


December 10, 2013

Capital IQ does not generate reports with different ranking methodologies for the

same issuer. However, in the event that different methodologies or data are used on

the analysis of an issuer, the methodologies may lead to different views or

recommendations on the issuer, which may at times result in contradicting

assessments of an issuer. S&P Capital IQ reserves the right to alter, replace or vary

models, methodologies or assumptions from time to time and without notice to

clients.

STARS Stock Reports:

S&P Capital IQ Global STARS Distribution as of September 30, 2013

Ranking North America Europe Asia Global

Buy 36.5% 33.5% 32.3% 35.6%

Hold 54.2% 43.5% 59.5% 53.1%

Sell 9.3% 23.0% 8.2% 11.3%

Total 100.0% 100.0% 100.0% 100.0%

STARS Stock Reports are prepared by the equity research analysts of Standard &

Poor’s Investment Advisory Services LLC (“SPIAS”). All of the views expressed

in STARS Stock Reports accurately reflect the research analyst’s personal views

regarding any and all of the subject securities or issuers. Analysts generally

update stock reports at least four times each year.

Quantitative Stock Reports:

The Fair Value ranking distribution is a fixed distribution based on relative

weightings as described in the Glossary section of this report under S&P Capital

IQ Fair Value Rank. Certain reports with Fair Value Rank do not have a

Buy/Hold/Sell recommendation, for ranking definition please refer to the

Glossary section of the respective report. The Fair Value Ranking distribution

includes all the stocks that have S&P Fair Value Ranking.

Quantitative Stock Reports are prepared by the equity research group of SPIAS.

All of the views expressed in these reports reflect S&P Capital IQ’s research

models output regarding any and all of the subject securities or issuers.

Quantitative Stock Reports are updated daily. Quantitative Stock Reports rely on

the availability of data and therefore SPIAS do not provide a report when

sufficient data is not available.

STARS Stock Reports and Quantitative Stock Reports:

No part of analyst compensation and SPIAS’ compensation was, is, or will be,

directly or indirectly, related to the specific recommendations or views

expressed in Stock Reports and/or Quantitative Stock Reports, as applicable.

About S&P Capital IQ’s Distributors:

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S&P Capital IQ or an affiliate may license certain intellectual property or provide

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Indexes are unmanaged, statistical composites and their returns do not include

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S&P Capital IQ and its affiliates provide a wide range of services to, or relating to,

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General Disclaimers Notice to all jurisdictions:

Where S&P Capital IQ’s Research Reports are made available in a language

other than English and in the case of inconsistencies between the English and

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Past performance is not necessarily indicative of future results.

S&P Capital IQ, its affiliates, and any third-party providers, as well as their directors,

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Ratings from Standard & Poor’s Ratings Services are statements of opinion as of

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purchase, hold, or sell any securities or to make any investment decisions. S&P

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when making investment and other business decisions. S&P’s opinions do not

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Standard & Poor’s Ratings Services does not contribute to or participate in the

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Research Reports are not intended to be investment advice and do not constitute

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or strategies mentioned herein may not be suitable for all investors and this

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investor’s particular investment objectives, financial situations or needs. Any

opinions expressed herein are given in good faith, are subject to change without

notice, and are only current as of the stated date of their issue. Prices, values, or

income from any securities or investments mentioned in this report may fluctuate,

and an investor may, upon selling an investment, lose a portion of, or all of the

principal amount invested. Where an investment is described as being likely to

yield income, please note that the amount of income that the investor will receive

from such an investment may fluctuate. Where an investment or security is

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from that investment to the investor. The information contained in Research

Reports does not constitute advice on the tax consequences of making any

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December 10, 2013

particular investment decision. Before acting on any recommendation in this

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Additional information on a subject company may be available upon request.

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December 10, 2013

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December 10, 2013

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