Reflation trade resurfaces, but has its limitations

Strategy: now overweight eurozone real estate

13 Feb 2017

  • Japanese consumer spending slows, business investment a bright spot
  • China and India surprise with hawkish monetary policies
  • Taking profits on the overweight in US small caps

After a pause, the global reflation trade has reappeared. The idea is that higher nominal growth, as the extremely stimulative monetary policy of recent years finally takes hold, supports corporate profit margins and thus benefits equities. Of course, bond yields should not rise too quickly since that could spoil the party and labour costs should be contained. Downward risks and expensive-looking equities have caused us to hold on to our underweight in developed equities. We closed our overweight in US small caps, but as a hedge, we opened a long position in eurozone real estate versus eurozone government bonds (see below).


The Japanese economy grew by 1.2% QoQ annualised in the fourth quarter of last year, taking full-year GDP growth to 1.0%. This is slightly faster than the pace at which the Japanese economy can grow in the longer term given a declining working age population and modest productivity growth. Japanese GDP data tends to be quite volatile and given the relatively low trend growth, registering four straight quarters of growth is quite an achievement. The last time this happened was when the economy was recovering from the financial crisis in 2009/10. One main caveat: initial Japanese GDP data can be revised significantly.

The latest GDP data clearly shows the tug of war between domestic and external forces. Yes, the labour market looks tight, but this has generated hardly any wage gains. With some growth in employment, total household income is rising, but in the fourth quarter consumers decided not to spend this extra income. Consumption growth was zero.

Growth was supported by net trade as exports rose by 11.0% QoQ annualised and imports by 5.4%. Business investment was positive, but residential investment growth virtually halted. The Japanese yen has strengthened lately, but this was a small move compared with the big swings seen in recent years and the inflationary impact of this yen strength should fade.

In the fourth quarter the GDP deflator – the broadest price gauge of any economy – fell by 0.1% YoY. But inflation was supposed to be positive, right? Well, only if it is inflation driven by economic growth and a closing output gap. Inflation from higher oil prices or a weaker yen curbs consumer spending power. Anyway, some income growth, stronger producer sentiment and fiscal support should allow the economy to grow at or slightly above trend this year.

Will this make a difference for the Bank of Japan? Probably not for the time being. There are hardly any inflationary pressures. At the end of January the BoJ decided to keep monetary policy unchanged, while only two out of nine policymakers voted for higher rates. The 10-year yield has drifted towards 0.1% and this has coincided with a stronger yen. Thus, the BoJ may have to increase its asset purchases to ensure its policy remains credible.


Against market expectations, the People’s Bank of China (PBoC) tightened monetary policy, while the Reserve Bank of India (RBI) ended its easing cycle.


We have often pointed to the overly fast credit expansion so for us it is positive that the authorities seem to have started to address China’s high dependency on credit. They face a delicate balancing act. Moving slowly would further inflate the credit bubble, while moving too fast would risk a hard landing of the economy. The PBoC has raised several market-based rates by a modest 10bp, effectively signalling an end to the excessive monetary stimulus. The signal has been picked up by the bond market and 10-year yields have surged. This is something to watch for as significant monetary and fiscal stimulus in 2016 helped stabilise the economy, but both these growth drivers are now turning. Unfortunately we have entered into that part of the year around the Chinese New Year where data is volatile or not even published, so we will have to wait before we get a better view of the Chinese economy.


The central bank was approaching the end of the easing cycle, but halting it now came as a surprise. The economy is suffering from demonetisation in which it was decided that large banknotes were no longer legal tender. The manufacturing and services sector PMIs are below 50 and industrial production and consumer price inflation have fallen. Still, the RBI left its rates unchanged and indicated its policy stance had turned neutral from accommodative, effectively signalling an end to the rate-cutting cycle. Apparently the RBI is ready to look through what it sees as temporary weakness in growth and inflation. Still, bond yields jumped on the RBI move.


In the US, consumer confidence fell, but this was from a high level. Interestingly, the Democrat’s Expectations Index is close to its historic low (indicating recession) while the Republican’s Expectations Index is near its historic high (indicating expansion). While it is reasonable to expect the gap to narrow to match a more moderate pace of economic growth, it has been long known that negative rather than positive expectations have a greater effect on spending, so any forecasts should take into account downside risks to consumer spending.

Political uncertainty has remained high since it is still unclear how a possible corporate tax cut, a limit on interest-rate deductibility, repatriation of foreign profits and a ‘border adjustment’ tax would play out. The message from the new administration has been hardly consistent so far.

In the eurozone the focus is on upcoming elections. Sure, there are downside risks, but we give them a low probability. In the Netherlands the anti-immigration and anti-EU PVV may get the most seats in the lower house in the March elections, but it will most likely not be able to form a coalition government. In France, reform-minded Emmanuel Macron looks set to win in a second round of the presidential elections in May. Actually, a lack of reforms, slow growth, a troubled banking sector and high government debt in Italy may be a bigger risk for the eurozone.


We were overweight US small caps, expecting them to outperform in a domestically centred fiscal push for growth and be more insulated against any protectionist measures. After the outperformance since the US election, small caps had become even more expensive relative to large caps. Even though earnings are improving for small and large caps, we think the price gains by small caps are not justified by the relative earnings momentum. With too much optimism priced into small caps, we decided to take profits.



Since we still wanted to have a hedge against positive moves in risk assets, we have gone overweight eurozone real estate versus eurozone government bonds. Relative to the underlying assets, eurozone listed real estate is not cheap, but its dividend yields are high relative to credit yields. We are positive on the eurozone economy, but see limited upside potential for government bond yields. We expect the ECB to continue with quantitative easing throughout the year. So, demand for commercial real estate should improve, while supply is still limited.


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