EARNINGS OVERVIEW AND OUTLOOK. EXHIBIT 1: EUROPE EARNINGS PER SHARE (EPS) BY SECTOR % change (y/y) Cons. Disc. Care

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1 MARKET INSIGHTS Market Bulletin 28 February 2017 European equities: Q4 earnings review and outlook for 2017 IN BRIEF With 72% of companies having reported, we estimate that Q earnings per share (EPS) growth was 9.3% year-on-year (y/y) for the Euro Stoxx 600. We have a positive outlook for earnings growth in the next 12 months, supported by a weaker euro, higher commodity prices and stronger global growth. But current consensus forecasts for 2017 look overly optimistic. Despite a strong fourth-quarter rally, the current inflation and growth outlook for 2017 favours cyclical sectors over defensive ones. Higher bond yields and progress on Italian banking issues have eased the pressure on European banks. However, we remain cautious due to the potential for political volatility. EARNINGS OVERVIEW AND OUTLOOK The fourth quarter of 2016 looks to have been a strong one for European equity earnings. With 72% of companies having reported, we estimate that Q earnings per share (EPS) growth was 9.3% (y/y) for the Euro Stoxx 600. Encouragingly, earnings were lifted by a broad-based improvement across eight of ten sectors, with only energy and technology registering negative growth in the fourth quarter (Exhibit 1). Energy earnings, despite being negative, are becoming less of a headwind to regional earnings growth as the oil price continues to recover. AUTHOR Alex Dryden, CFA Global Market Strategist Broad-based improvement in earnings performance by sector is a positive for European equities in 2017 EXHIBIT 1: EUROPE EARNINGS PER SHARE (EPS) BY SECTOR % change (y/y) Materials Health Care Cons. Disc. Industrials Telecomms Financials Cons. Staples Source: FactSet, MSCI, J.P. Morgan Asset Management; data as of 27 February Total Utilities Energy Tech. 1 Forecasts provided by I/B/E/S estimates from Thomson Reuters.

2 Furthermore, financials, which make up over 20% of European equity markets, are also showing progress. Higher bond yields around the world have helped boost earnings by supporting trading revenues as well as net interest margins. Looking ahead, current forecasts for 2017 are for 14% (y/y) growth in earnings per share (EPS), 2 a significant improvement on -1% (y/y) for the whole of These upbeat forecasts can be explained by a range of factors: Stronger global and domestic growth: Global Manufacturing Purchasing Managers Indices (PMIs) hit a multi-year high in January, implying global growth of 3-3.5% in Eurozone PMIs are also at their highest levels since Rising commodity prices: Consensus forecasts are for an oil price of US$60-65 by the end of 2017, supporting the energy sector s earnings recovery. Higher bond yields: Higher yields and a steeper yield curve help banking profits by boosting net interest margins. Weaker currency: The Stoxx 600 sources approximately 45% of its earnings from overseas. The euro is trading close to multi-year lows against the US dollar, providing an automatic boost to earnings. Margin expansion: Increased inflationary pressure and improving economic conditions have pushed margin growth to its highest level in three years. However, investors should be cautious about headline earnings estimates for Analyst forecasts typically start the year at overly optimistic levels before falling sharply over the next 12 months. Forecasts for European earnings growth in 2016 began the year at 7% before sliding as earnings growth failed to materialise. We believe that the tailwinds are in place for decent European earnings growth in 2017; however, we would be more comfortable with estimates of mid to high single-digit earnings growth. THE CASE FOR EUROPE 2016 was the worst year for European equity outflows since the financial crisis, as investors turned away from Europe and towards emerging markets and US equities. At the start of 2017, should investors consider allocating back to the region? Global equity markets are not as cheap as they used to be. The S&P 500 is trading at a price-to-earnings ratio of 17.7x forward earnings, 11% above its 25-year average. In this world of relatively expensive valuations, investors may want to look again at Europe. As Exhibit 2 shows, the relative price-to-book (p/b) ratio of European equities vs. US equities is over one standard deviation below its long-run average, one of the largest differences on record. Political worries are weighing on valuations of European equities relative to their US peers EXHIBIT 2: EUROPE VERSUS US VALUATIONS Relative p/b ratio St. Dev +1 St. Dev Average 0.55 '92 '94 '96 '98 '00 '02 '04 '06 '08 '10 '12 '14 '16 Source: FactSet, MSCI, J.P. Morgan Asset Management; data as of 27 February Investors are understandably concerned about the political risk in the region. In February we released a paper entitled The European political project at a crossroads? which addressed some of these concerns and explained why investors political fears may be overdone. When the political clouds begin to clear, investors will be able to see that the fundamentals in Europe have improved, and this should begin to correct the relative valuation difference between European equities and their US peers. 2 Forecasts provided by I/B/E/S estimates from Thomson Reuters. 2 EUROPEAN EQUITIES: Q4 EARNINGS REVIEW AND OUTLOOK FOR 2017

3 POSITIONING IN 2017: CYCLICAL OR DEFENSIVE? In the fourth quarter of 2016, the European economy was beginning to show signs of heating up. As we highlight in Exhibit 3, regional economic data has consistently beaten pessimistic forecasts in the last few months as a cyclical economic upswing has taken hold. Only recently has equity performance begun to reflect the underlying fundamentals of the eurozone economy EXHIBIT 4: EUROZONE GDP VERSUS CYCLICAL/DEFENSIVE PERFORMANCE % (LHS); relative index level (RHS) European cyclical/defensive Eurozone economic data continues to surprise on the upside, helping to support the case for cyclical sectors EXHIBIT 3: EUROZONE ECONOMIC SURPISE INDEX Index level Eurozone GDP (y/y) -6 '97 '99 '01 '03 '05 '07 '09 '11 '13 '15 Source: MSCI, FactSet, J.P. Morgan Asset Management; data as of 27 February Feb 16 Apr 16 Jun 16 Aug 16 Oct 16 Dec 16 Feb 17 Source: FactSet, MSCI, J.P. Morgan Asset Management; data as of 27 February We acknowledge that cyclical stocks have rallied strongly in the last few months. As Exhibit 5 highlights, relative valuations between cyclical and defensive stocks are around their longterm average. However, economic conditions remain supportive for a continuation of the cyclical rally in the first half of Furthermore, higher bond yields, driven by higher inflation, will continue to put pressure on defensive sectors. Investors have long been sceptical about the European recovery, and a cautious stance towards European equities has rewarded investors. Between 2013 and June 2016, defensive stocks rallied 36%, compared to a 7% return from cyclical sectors. However, this scepticism looks to have reversed course in the second half of Exhibit 4 highlights that the divergence between economic fundamentals and the relative performance of cyclicals closed sharply in late The prospect of stronger global growth, higher inflation and higher yields has seen global cyclical stocks significantly outperform defensive sectors since the US election. Cyclical valuations are now around their long-run averages after strong performance in Q EXHIBIT 5: EUROPEAN CYCLICALS VERSUS DEFENSIVE: PRICE/BOOK Index level '97 '99 '01 '03 '05 '07 '09 '11 '13 '15 Source: MSCI, FactSet, J.P. Morgan Asset Management. Cyclical sectors are financials, industrials, materials, consumer discretionary and technology. Defensive sectors are consumer staples, utilities, health care and telecommunications. Data as of 27 February J.P. MORGAN ASSET MANAGEMENT 3

4 EUROPEAN BANKS: WILL THEY REBOUND IN 2017? In a previous publication, European banks: It s not all bad news (October 2016), we highlighted the fact that European banks were stable but not particularly profitable. A sluggish economic recovery, large amounts of non-performing loans, regulatory pressures and a flat yield curve were all to blame. However, a rebound in global bond yields helped to lift the fortunes of European banks heading into The sector has gained 40% since the German 10-year yield hit a record low of -0.20% in June 2016, as a steeper yield curve supports net interest margins. The recovery in European banks in the fourth quarter has also been helped by political progress on the Italian banking issues. This is a step forward for Europe, as Italy has been the laggard when it comes to banking reform. To investors, concerns over Italian banks may feel like another chapter in the long-running saga of the European banking crisis; in fact, this is the final chapter. Italy is the last major banking system that requires an overhaul, and a solution to its woes may close the book on the European banking crisis. European banks look cheap relative to the index; however, the sector may be used as a proxy for political risk in 2017, creating volatility EXHIBIT 6: RELATIVE PRICE-TO-BOOK VALUE OF EUROPEAN BANKS VERSUS INDEX Index level '99 '01 '03 '05 '07 '09 '11 '13 '15 '17 Source: MSCI, FactSet, J.P. Morgan Asset Management; data as of 27 February Average Banking reform, combined with faster growth, is also helping improve the quality of European bank balance sheets. Nonperforming loans in the eurozone are slowly declining, representing 5.1% of total loans in the second quarter of 2016, down from a peak of 6.4% in 2015, though still far above the 2.9% level of before the financial crisis. 3 However, given the challenging regulatory environment, as well as the very large number of banks in the region, the sector is not completely out of the woods just yet. Should investors therefore be more optimistic on European banks in 2017? As Exhibit 6 highlights, European banks look very attractive on a relative valuation basis vs. the wider market, which may attract some risk-seeking investors. However, part of the decline in valuations since the financial crisis may be justified given higher capital regulation and less profitable trading divisions. Therefore, banks may not regain their previous levels. Investors should also expect volatility in the European financial sector this year as it is likely to be viewed as a proxy for political risk. Any signs of major gains for populist parties in upcoming elections in Europe could see financials sell off sharply. 3 European Central Bank, all data is gross non-performing loans as a percentage of the total. 4 EUROPEAN EQUITIES: Q4 EARNINGS REVIEW AND OUTLOOK FOR 2017

5 INVESTMENT IMPLICATIONS Earnings growth in 2017 should be supported by stronger global growth, a weaker euro and a recovery in both the energy and financial sectors. However, current consensus forecasts are likely to prove too optimistic. Investors should expect decent but not stellar earnings growth this year. Stronger growth, higher inflation and rising bond yields mean that we continue to favour cyclicals over defensives, despite the strong rally in cyclical sectors. A steeper yield curve and progress towards a resolution of Italy s banking issues have eased the pressure on European banks. However, it may be too soon to jump back into the sector. Financials are likely to be used as a proxy for political risk in 2017, and a busy and uncertain electoral calendar in the next few months is likely to trigger volatility amongst European banks. J.P. MORGAN ASSET MANAGEMENT 5

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