Doubts About The “Reflation Trade”

A number of commentators have characterized the recent recovery in stock prices as a so-called “reflation trade”. Our Global Investment Strategy service is skeptical of this interpretation.


For one thing, gold – the classic barometer of reflationary trends – continues to tank. Moreover, there is a limit to what central banks can realistically do to reflate the economy: interest rates are already close to zero in most countries and there is little appetite for additional QE. Yes, central banks can undertake more radical measures but this would only happen in the depths of a crisis.

If anything, the pattern over the past few years has been one where central banks have backed off from additional easing measures once risk sentiment has begun to improve. We saw a flavor of this over the last ten days. While the Bank of England struck a decidedly dovish tone, other central banks have turned a bit more hawkish. Most notably, the Fed stressed in last week’s FOMC statement that a December rate hike was still very much in play, despite growing evidence that the turmoil in emerging markets is starting to spill over into U.S. manufacturing performance. The Bank of Japan also dashed hopes that it would expand its QE program, deciding instead to sit on its hands while hoping for growth and inflation to pick up. Following the BoJ’s example, the Reserve Bank of Australia kept rates on hold, disappointing investors who were hoping for a rate cut. Even Mario Draghi, who only two weeks ago surprised the market by suggesting that more QE and a lower deposit rate were in the works, seemed to walk back a bit from his statement by saying further easing was “an open question”.

Tactically, Fed’s hawkish rhetoric is a threat to stocks. Please see the next Insight, (Part II) Doubts About The “Reflation Trade”.

Don’t Give Up On U.S. Pharma

U.S. pharmaceutical stocks have been a juggernaut throughout the most intense valuation expansion phase of the bull market since 2012. The group has ticked all the boxes, providing growth, safety, yield and a chance to harvest takeover premiums during the M&A frenzy. Despite the recent bounce of market turbulence, our U.S. equity team believes pharma stocks have more room to outperform.


Momentum investors have abandoned a number of previous equity sector leaders, including the overall health care sector in general, and the pharmaceuticals and biotech indices in particular. But the S&P pharmaceuticals index should not be lumped into the same category as biotech stocks. Biotech is up more than 120% in relative performance terms. Pharmaceutical stocks have also outperformed the broad market, but by a more modest 29%; it has not been the object of the same sort of speculative zeal.

One oft-noted headwind for pharma stocks is that drug prices have suddenly become a hot political issue heading into an election year. A few drugs have experienced headline-grabbing exorbitant price increases; these incidents represents only a miniscule fraction of total drug spending, but have roiled policymakers nonetheless. Nevertheless, the political maligning of drug price increases is not new. The U.S. is one of the few countries that operate with little drug pricing regulation. Manufacturers charge as much as insurers and hospital groups will pay. If drug prices become overly punitive, then the major buyer groups will simply opt for alternatives and/or remove drugs from their approved lists. The benefits of this model are that the U.S. is the largest drug R&D spender in the world; this level of spending accrues incrementally to innovation and new product introductions much earlier in the U.S. than more highly regulated countries.

Price controls have downside risk as well, including reduced safety if drug imports are allowed where quality is suspect (already, a number of foreign generic manufacturers are not up to standard, limiting the supply of some medicines, and ironically, causing price inflation), and the potential for less R&D spending. We have little insight as to how the U.S. political landscape will shift, but history suggests focusing primarily on market rather than political forces is a more worthwhile endeavor, please see the next Insight, (Part II) Don’t Give Up On U.S. Pharma.

EM Corporate Health: Profitability

Our EM strategists’ analysis of nine non-financial sectors across 18 EM countries has not revealed widespread signs of improved corporate profitability or profit margins:


Net profit margins for EM non-financial companies have dropped to well below their 2008 lows. Notably, the decline is broad-based: seven out of nine sectors have seen their net profit margins shrink. Only technology and consumer services have seen their margins improve.

The return on equity (ROE) for non-financial EM companies has also plummeted below its 2008 lows. Excluding technology and consumer services, ROE has dropped in all other sectors.

Furthermore, the measure of operating profitability – calculated as EBITDA-to-assets – has also been drifting lower. Like other measures of profitability, the drop in this measure is broad-based across sectors. This shows that while EM companies have increased assets, those investments/new assets have not produced additional profits. On the contrary, profits have massively disappointed. As a result, return on invested capital has dropped sharply.

Lastly, another measure of corporate efficiency is assets turnover, calculated as the ratio of sales to assets. This too has plummeted in all sectors except health care.

Amid plunging return on capital and return on equity, leverage has skyrocketed in the majority of EM countries and sectors as highlighted in the next Insight, (Part II) EM Corporate Health: Leverage.

U.S. Growth: Worries About 2016

Our Global Investment Strategy service is concerned about how the U.S. growth picture will unfold next year.


The Great Recession created a lot of pent-up demand, which has slowly been exhausted over the past few years. Auto sales are now close to their pre-crisis peak, while business capex has returned to the level consistent with the economy’s long-term growth prospects. The renormalization in demand in just these two areas contributed 0.9 percentage points to growth over the past five and a half years, but is likely to contribute only 0.3 points over the next two.

On the positive side, residential construction should continue to increase. However, given that homebuilding activity has already been slowly recovering over the past few years, the incremental impact on growth should be minimal. A bit less fiscal drag will also help, but again, we have seen a fair bit of renormalization on that front already – government spending on goods and services contributed 0.23 percentage points to growth in the first half of this year, and an average of 0.15 points over the past five quarters. This is a huge improvement over the Q4 2009-to-Q4 2013 period, where government spending subtracted an average of 0.4 points from GDP growth.

Credit growth has been increasing over the past few years from a low of around -4% in 2009 to around 5% at present, representing a massive 9-percentage point swing. As credit growth stabilizes at a rate close to that of nominal GDP growth, the so-called credit impulse will fall back to zero. That could shave around 0.5-1 percentage points from growth. The implication is that even if the Fed does raise rates in December, it will not be able to raise them very much thereafter. On top of all that, policy uncertainty is rising, please see the next Insight, A Bout Of U.S. Policy Uncertainty?

BoJ To Boost Japanese Stocks

Buy Japanese stocks in advance of the BoJ meeting on October 30th.


The Japanese economy has clearly slowed of late. Growth turned negative in Q2, and the latest data on industrial production and exports suggest that the economy likely contracted again in Q3. Meanwhile, inflation expectations continue to fall, threatening the progress the BoJ has achieved in lowering real rates. The souring economy, together with the global selloff in stocks, has pushed down the Nikkei, which now stands 13% below its August highs. Our Global Investment Strategy service thinks this is a good time to increase exposure to Japanese equities.

The BoJ is likely to decide to further augment its QE program at the October 30th meeting. Given that the BoJ is already absorbing more than 100% of the net issuance of JGBs, its firing power is likely to focus on equity ETFs and J-REITs. This will provide a new and important source of demand for Japanese stocks.

We also expect Japanese policymakers to continue to take steps to encourage companies to return more cash to shareholders in the form of increased dividends and share buybacks. Such steps partly reflect the desire to improve shareholder governance, but there is a macroeconomic imperative as well: Japanese companies are sitting on more cash than their entire stock market capitalization; returning some of that idle money to shareholders could boost consumption and mitigate deflationary pressures.

Against the backdrop of attractive equity valuations, the double-punch of BoJ equity purchases and more shareholder-friendly policies should give Japanese stocks a boost.