Weekly commentary: do we underestimate reflation?

Last week: central banks' swap deal fueled stocks
November was really close to turning into a very ugly month but then a string of events sparked a month-end rally with last week as the saver. Firstly, rumours of an International Monetary Fund (IMF) plan to backstop Italy worth EUR 600 bn. started the rally on Monday, then on Wednesday it was a big surprise when first the People's Bank of China lowered its Reserve Requirement Ratio for its major banks followed by the syndicated U.S. Dollar swap agreement by the world's six major central banks to help rectify the U.S. Dollar funding squeeze for European banks. For the remainder of the week markets rode the intervention fever in combination with positive numbers on the US economy as ISM manufacturing came out better than expected and US Nonfarm payrolls added 120K jobs in November. Of most interest was the household survey which showed yet again strong numbers (read our Friday's comment on the US labour figures). The week ended with the S&P 500 Index up 7.4 percent, Euro STOXX 50 Index up 11.0 percent and Nikkei 225 Index up 5.9 percent.

Are monetary policies diluting the negative effects of political stupidity?
When we observe the world today it is clear we have immense imbalances across the developed and developing economies. There exists a huge mismatch between savings and debt levels between the old (developed) and the new (developing) world/economies. It is also obvious that a deleveraging process is progressing and which will potentially last for a minimum one decade. Deleveraging is a painful but necessary process when an artificially created credit boom has run out of steam.

Normally central banks can reignite economic growth by lowering funding costs through key interest rate cuts but the game changes when we are in a deleveraging scenario as monetary policies cannot rectify the negative effects of high debt burdens in the private sector; if you have too high debt lower interest rates do not change your situation.

Our greatest fear is that extensive and accommodating monetary policies will freeze the necessary structural reforms that are needed to ignite economic growth again; those reforms are lower taxes across the board, elimination of government subsidies, the rolling back of entitlements and the reduction of bureaucracy.

The massive reflation strategies implemented by central banks can prop up asset prices and make the economy grow on a nominal basis pushing corporate sales and earnings up; we have seen that for centuries and history tells us it is very destructive for the real economy. But look how sales (see chart below) are already growing at 10 percent annualised despite a weak economy due to reflation. While we are aware of the structural issues in the developed world it can sometimes be devastating to prematurely call for a major collapse in stocks as a reflation can prolong the insanity for years and with inflation running at 3.5 percent (officially) savers cannot afford to miss a stock rally caused by reflationary policies when bond yields are not covering the rising price level.


Looking at our global valuation model equities also became cheaper in November as valuation metrics and decreasing debt-to-equity continue to hold down relative valuations on a historical basis.

Our global valuation model split into sectors still highlights utilities, financials and health care as the cheapest sectors, relatively.