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Year of Turmoil for China’s Health Care

2013 has been an eventful year for China’s health care industry. There were several investigations into allegations of corruption and bribe-taking by doctors. The ensuing government crackdown dampened sales among both domestic and multinational drug firms. While “incentives” such as leisure trips for doctors, billed as conferences, are believed to have long been a common industry practice, the issue has not drawn much attention in recent years. The widespread distrust of doctors and hospital staff in China, along with often poor health care services, have led to a string of recent physical attacks on health care workers. Disgruntled patients and their relatives have resorted to violence. And while violence against doctors is also nothing new, what has been a growing trend is the rising frequency and severity of the attacks. Some doctors have taken to the streets to ask for understanding and justice from their communities and some hospitals have even offered self-defense lessons to hospital staffers.

Corruption in China’s health care industry is believed to be fueled in part by the low base pay of doctors in not-for-profit public hospitals. While most Chinese hospitals are not-for-profit public hospitals, government funds provide only a small portion of a hospital’s needs. As a result, many hospitals rely on drug sales to make ends meet. It’s also typical for a doctor in larger state-run hospitals to see as many as 50 patients a day. Some of these doctors have also turned to other methods, such as collecting commissions from pharmaceutical companies whose drugs they promote, to supplement their income. Many patients are aware of this but feel they have little choice but to follow doctors’ orders.

In my view, unless public hospitals are allowed to increase their fees, and unless doctors at state-run facilities are paid as well as those from private hospitals, industry corruption seems likely to persist. The government seems aware of this. During its recent Third Plenary meeting, China’s leadership pledged to reform the performance evaluation and incentive system in hospitals, encourage the development of more private hospitals and allow doctors to practice at multiple sites. These measures are good news, although easier said than done. In my opinion, these reforms are necessary, especially as China continues to struggle with a rapidly aging population. The industry will need to adapt to tackle the country’s long-term health care challenges, however, it is demonstrating an encouraging willingness to do so.

Hardy Zhu, Research Analyst at Matthews Asia

The views and information discussed represent opinion and an assessment of market conditions at a specific point in time that are subject to change. It should not be relied upon as a recommendation to buy and sell particular securities or markets in general. The subject matter contained herein has been derived from several sources believed to be reliable and accurate at the time of compilation. Matthews International Capital Management, LLC does not accept any liability for losses either direct or consequential caused by the use of this information. Investing in international and emerging markets may involve additional risks, such as social and political instability, market illiquidity, exchange-rate fluctuations, a high level of volatility and limited regulation. In addition, single-country funds may be subject to a higher degree of market risk than diversified funds because of concentration in a specific geographic location. Investing in small- and mid-size companies is more risky than investing in large companies, as they may be more volatile and less liquid than large companies. This document has not been reviewed or approved by any regulatory body.

The Weather is Set Fair for 2014

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El tiempo será apacible en 2014 — Matthew Beesley, Head of Global Equity, Henderson Global Investors. The Weather is Set Fair for 2014

There was a British weather forecaster, Michael Fish, who gained notoriety in 1987 on the eve of what was to become one of the largest storms ever to hit the UK, when he opened his bulletin by saying: “Earlier on today, apparently, a woman rang the BBC and said she heard there was a hurricane on the way … well, if you’re watching, don’t worry, there isn’t…”

It wasn’t quite career suicide, but it was certainly a lesson in being emphatic in the face of uncertainty. And there is an overwhelming temptation when making predictions about equity markets to avoid the emphatic. Furthermore, the very nature of looking forward to a new year implicitly suggests that what lies ahead will be different to what we are leaving behind. For equity investors in 2014, this may not be the case: we are currently in the midst of a synchronized global economic expansion, albeit a rather tepid one, and in our opinion all the evidence suggests this is likely to continue. In the eurozone, 2013 became the year when conditions moved decisively from ongoing deterioration to at the very least becoming ‘less worse’, while a recovering housing market has been key to the return of UK consumer confidence. In the US, forced reductions in government expenditure have certainly impacted growth rates, but on balance the US economic recovery is increasingly broad-based.

For equity markets to rise meaningfully, however, we would argue that the expectation of growth in corporate profits needs to become a reality. Profit margins are at all-time highs in the US, but there is room for a meaningful recovery in Europe and Japan. It would be our expectation that after five years of aggressive cost-cutting in Europe – and longer in Japan – that any top-line recovery leverages into some more impressive bottom-line growth. This could positively surprise not just investors, but in some cases management teams too, given their much needed aggressive focus on costs during recent tough economic times. However, with valuations having already increased in anticipation of this, any disappointments here mean negative consequences.

Forecasting the weather is a challenging occupation. From what we see, however, largely informed by the hundreds of company management meetings that we conduct globally, we think the weather is set fair. There are those who are warning there is a storm called deflation coming our way. But for now, don’t worry, there isn’t…

Opinion column by Matthew Beesley, Head of Global Equity, Henderson Global Investors

Entrepreneurship in Asia

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Emprender en Asia — . Entrepreneurship in Asia

We have witnessed the rise of many successful entrepreneurs in Asia over the past few decades. One criticism of their success, however, has been that their businesses often were developed through “copying” or learning from Western businesses. It is true that their businesses have not been as revolutionary as some Western businesses have been. There is nothing inherently wrong with this, nor should it be surprising at Asia’s current stage of economic development. But we do not believe this model will always be the case.

Many policymakers in Asia have made innovation a national, strategic priority. In the past two decades, they have narrowed the gap in research and development (R&D) with their Western peers through rising R&D spending in academia and increasing technology transfer by attracting knowledge-intensive foreign direct investments (FDI), which taps a pool of more highly educated workers. The effort has given rise to numerous research hubs equipped with good infrastructure and skilled workers. Driven by the explosion in Internet penetration and rising personal income, private sectors have become more active and funding for start-ups is increasing as more angel and venture capital communities develop.

R&D Funding

Since the early 1990s, greater emphasis on science and engineering has significantly improved the overall quality and quantity of such professionals in Asia. This effort increased Asia’s share of global R&D expenditure to 32% in 2009, up from 24% in 1999.

This increase was supported by both growing GDP and increased spending for R&D, with results most evident in China and South Korea. The rising amount of funding going into the sciences, predominantly in China, Taiwan and South Korea, has led to more students pursuing related higher education degrees. The number of science and engineering degrees earned in China and Taiwan more than doubled between 2000 and 2008, and accordingly, the increase in such graduates has raised Asia’s labor supply of scientists.

Industrial Policies
Governmental development policy has generally built up good infrastructure and created an educated and knowledgeable labor force. Taiwan, South Korea and Singapore have had success after their respective governments focused on developing specific sectors like semiconductors, automotives and airlines. In the past decade, less mature Asian economies have utilized methods like public procurements and technology funds to implement their industrial policies aimed at boosting local innovation. Increasingly, they are also using FDI to achieve their objective by increasing technology transfer.

However, traditionally, instead of developing a network of local suppliers, foreign companies have sourced from the same suppliers due to a lack of scale or due to trust and quality. As a result, governments have increasingly offered various financial incentives for foreign multinational corporations to conduct R&D in Asia’s science parks. Today, according to UNESCO, there are over 400 science parks worldwide. While the U.S. and Japan top the list with more than 110 centers each, China—which did not start developing science parks until the mid-1980s—already has approximately 100.

As a result, U.S. multinational corporations are increasingly allocating R&D projects to their foreign affiliates in Asia Pacific ex-Japan, whose R&D project value grew more than seven-fold from 1997 to 2010. These activities are driving the rise of hubs equipped with technology infrastructure and well-educated labor pools across Asia, which is a precondition of start-ups‘ creation and expansion.

Through this link you may access the full report “Entrepreneurship in Asia”, by Jerry Shih, CFA, Research Analyst, Matthews Asia

The Third Plenum

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The Chinese government recently released details of the reforms announced at the Third Plenum and the market has reacted positively. The Plenum is a key meeting of top Communist Party leaders to discuss China’s future policy direction. At the center of the policy changes are reforms addressing the government’s role in the economy and business, and the introduction of more market-orientated mechanisms to guide the development of industries.

While the reforms will have varying implications for different industries, the reduction in the role of the state alone could spark a drop in the risk premium applied to the Chinese market where indices are dominated by mega cap state-owned enterprises (SOE) trading at low price-to-earnings and price-to-book value multiples. The Plenum also addressed critical reform agendas that will improve the prospects for social stability and the rise of consumption, such as relaxing the one child policy, increasing rural ownership and land use rights for farmers and those owning agricultural land, and changes to the ‘hukou’ system of urban social welfare entitlements, all of which can help rebalance the Chinese economy over the long term.

We believe that market sentiment will be lifted by the announced reforms as investors witness the improving quality of economic growth and evolution of the financial and real estate sectors as well as fiscal policy and pension systems. A re-rating of Chinese equity markets is also likely, with the Hang Seng China Enterprises H Shares Index currently looking cheap on a forward P/E ratio of less than 9x – see chart 1.

Chart 1: Is a Chinese re-rating overdue?

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Source: Datastream, Hang Seng China Enterprises H Shares Index, price earnings ratio, monthly data, 31 October 2003 to 31 October 2013.

The Chinese economy has continued its cyclical expansion with rising economic growth and industrial activity. Rising growth appears to be the result of government policy augmented by strengthening recoveries in Japan, Europe and the US. Clearer policy direction has certainly come from the Third Party Plenum. We believe there is sufficient scepticism over the Chinese story to allow ongoing positive surprises for some months. Stock picking should add value in this environment. We see abundant growth and value opportunities at present. Consumption stocks tend to be somewhat more expensive, but continue to offer high growth rates in earnings. Meanwhile, large state-owned enterprises (e.g. CNOOC) appear remarkably good value and valuations imply very negative outcomes, which we do not believe will occur.

Opinion column by Charlie Awdry, Investment Manager, China Opportunities Strategy, Henderson Global Investors.

A Shift From Liquidity to Fundamentals May Put Risk Assets Under Pressure

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De la liquidez a los funtamentales: posible escenario de presión para los activos de riesgo — Photo: David Illif. A Shift From Liquidity to Fundamentals May Put Risk Assets Under Pressure

As 2013 draws to a close, investors’ thoughts inevitably turn towards 2014 and the knowledge that risk assets will have to learn to begin to live without the seemingly unending flow of central bank liquidity. This presents some concerns as the earnings growth that many companies had banked on for the second half of this year has failed to materialise. If this trend continues, and the market’s focus shifts gradually from liquidity to fundamentals, risk assets may well come under pressure.

Excluding high yield, fixed income markets have had a lackluster year and we expect to see a similar trend in 2014

Excluding high yield, fixed income markets have had a lackluster year and we expect to see a similar trend in 2014. The continuing scramble for income has supported the high yield sector, which offers the highest level of income (relatively at least, although yields are low in historical terms) and the shortest duration exposure in the fixed income asset class. We regard corporate credit as a suitable asset class for a low-growth world and it is clear that coupon flows and maturities continue to easily absorb new issuance. Sectorally, financials remain in credit-friendly mode (and we expect them to remain so) but corporates appear to be increasingly equity-friendly, and thus leverage is rising. In core sovereign markets, yields will rise next year, particularly if the Federal Reserve delivers an earlier-than-expected taper (I still anticpate such a development at the end of March). However, we do not expect a rout in core markets and would anticipate 10-year US treasures to yield around 3.5% by end-2014. Sovereign markets such as the US and the UK are offering positive real yields, which will provide some valuation support in what is still a low-growth/income-hungry world.

We would anticipate 10-year US treasures to yield around 3.5% by end-2014

In terms of our recent activity, we have been taking some risk off the table in our multi-asset portfolios, primarily through reductions in emerging market equity and emerging market debt. The sell-off experienced by these asset classes in the summer, caused by concern over tapering fears, has provided a portent of events next year. Indeed, emerging market assets are likely to face a number of headwinds in 2014, namely rising treasury yields, a stronger dollar and a less benign liquidity environment.

We do not anticipate a re-run of 2013’s stellar returns but remain positive on the outlook for risk assets

Looking forward to next year, we do not anticipate a re-run of 2013’s stellar returns but remain positive on the outlook for risk assets. There are some developing tail risks (European deflation, Chinese/Japanese regional political tensions) that are not part of our core scenario, but which nonetheless provide potential uncertainty for markets should we see a continuing deterioration in the recent trends in these areas. China has thrown another wildcard into the mix with its recent announcements on domestic policy following the Third Plenum, which outlined a shift towards more market-friendly policies. However, as one would expect the timing, detail and implementation of these moves remains suitably vague.

Where Have All the Savings Gone?

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The last six years have witnessed the most severe financial crisis since the end of World War II, with household earning capacity and saving ability experiencing significant changes due to the downturn in the real economies. This challenging economic situation definitely affected household saving behavior, although the impact has been different in various countries – for some, the impact on household earning capacity was more intense than others.

European households endured a sizeable reduction in their per capita real gross disposable income (GDI), with the exception of Germany

Recently, members of Pioneer Investments investment team in Europe gathered research on Savings & Wealth Trends in 2007-2013. Their findings were very interesting and I wanted to share some highlights.

Holding Steady, Despite Challenges

European households endured a sizeable reduction in their per capita real gross disposable income (GDI), with the exception of Germany, which exhibited an increase. Saving rates for Germany and France, two countries historically characterized by high and stable levels of saving, did not show significant fluctuations in the last few years and are also expected to remain well above the 15% threshold in 2013. Japan is another country that has shown a stable saving rate (8.3% of income in 2012), although at lower levels compared to the two core euro area countries.

A “Change of Habit”, but Still Lagging Behind

The US and UK, typically considered among the highest “spenders” in the early 2000s, have shown a significant increase in the tendency to save, a sign of a “change of habit” after 2008. More restrictive credit market conditions, following the burst of the sub-prime crisis, are probably one of the main causes of this attitudinal shift. Despite the increase in saving, these two countries continue to be marked by relatively lower saving rates compared to the rest of the countries we analyzed.

Visible Declines

On the other hand, Italy, Austria, Spain and Greece have experienced a visible decline in saving over the last few years. We believe in these regions, the steep fall in incomes combined with higher taxes are key elements that have driven down the ability to save. In other words, the erosion of revenue, along with consumption levels that have not declined as rapidly, had a direct impact on household ability to accumulate resources for the future.

For 2013, with the market normalizing and some signals of a turnaround on the economic front, we believe saving rates will increase (compared to 2012) in Italy and Spain (11.9% and 8.5% respectively), while Austria should remain stable at 12%. We anticipate a further saving decrease in Greece (7.4%) and some reduction for Portugal, which is expected to revert to its historical average.

Household Wealth on the Rise?

Much of the volatility observed in household total net worth is a direct consequence of changes in financial asset prices. From 2009, most of the countries we observed underwent a period of uninterrupted growth in financial assets, thanks to both market appreciation and new money flowing into financial investments. Now, many of these financial assets have largely closed the gap in valuations with respect to 2008 (with the exception of Spain and Greece). In six year’s time, the strongest appreciation was reported by France and the UK, where household assets are now up 19% compared to 2007 values, followed by Austria (+17%) , Germany (+15%) and the US (+13%). More subdued asset growth was recorded for peripheral European countries, where the sovereign debt crisis weighed on both household confidence as well as asset valuations.

Between 2007 and 2013, German households, on the back of a buoyant economy, experienced the most significant progress in total net wealth (+23%). German and Italian households were least affected by the collapse of financial markets in 2008. Italy, however, was unable to recover and ended up with just a 2% increase in wealth over the six-year period. Japanese household results were worse as their net wealth is expected to be 5% lower in 2013 compared to 2007.

Household Net Wealth (in % to 2007 values)

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Source: OECD, National Statistics Institutes and Central Banks, as of September 30, 2013. 2013 estimates: Pioneer Investments.

With higher exposure of portfolios to equity markets, U.S. and UK households shouldered the most significant drop in wealth in 2008. However, following the upsurge in market prices after 2009, these countries were characterized by a much quicker upturn in wealth in the following years and are expected to end 2013 with a level of total resources equal to 10% and 16%, respectively, above pre-crisis levels.

In conclusion, the evolution of household incomes is a reflection of the crises that have repeatedly shaken the world’s economies, with particularly negative consequences in Europe, which reflected an almost generalized decline in real GDP in 2008-09 and again in 2011-13.

Note: For calendar years 2007 – 2012, measurements are as of December 31. For 2013, measurements are forecasted for year-end.

Article by Giordano Lombardo, Global CIO, Pioneer Investments. This article was originally posted on followPioneer on December 11th, 2013.

The views expressed here regarding market and economic trends are those of Investment Professionals, and are subject to change at any time. These views should not be relied upon as investment advice, as securities recommendations, or as an indication of trading intent on behalf of Pioneer. There is no guarantee that these trends will continue.

This material is not intended to replace the advice of a qualified attorney, tax advisor, investment professional or insurance agent. Before making any financial commitment regarding any issue discussed here, consult with the appropriate professional advisor.

Quality Franchises: Four Investment Themes to Close 2013

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Five years on from the onset of the financial crisis and reflecting on the evolution of markets in 2013, there has been general optimism. This has been reflected in fairly buoyant equity markets so far this year. As the world economy recovers, in our view, we expect markets to continue following the path of least resistance – upwards. That being said, there is always the risk that expectations rise too rapidly and stocks rise too quickly. We believe that investors should still be rewarded from holding equities, however, but to avoid shares of businesses like most banks that rely on a continued strengthening of the global environment in the event that these trends prove over-optimistic.

Below, we outline four top themes informing our portfolio construction now as we move to the close of 2013:

Positioning to cater for a broadly positive environment ahead – Whilst our portfolios are constructed on a bottom-up basis, we are mindful of the environment in which we operate. We hold 29 high-conviction ideas in the portfolio, which consist of time tested businesses that are steady compounders of cash flows.
Defensive tilt – Our high quality portfolio with its defensive tilt has limited exposure to industrials, consumer discretionary, financials, telecommunications and materials. These sectors are typically highly capital intensive, and thus names in which we would not have exposure through any market cycle. Informing our investment process is a belief in moving away from highly leveraged and capital intensive industries, preferring industries which are low in leverage and capital intensity, generate high free cashflows, with strong balance sheets and capital independence. We own only one direct Emerging Market share, Samsung Electronics, where the value in the share price is inconsistent with the dominance of the Franchise and the growth the business is producing and the investments it is making to extend its advantage over its peers.
Investing in quality global franchise businesses – Over the year to date, all companies in our portfolio have increased dividend payouts, nine companies have re-purchased shares and five have increased repurchases of shares. In addition, steady compounding of cashflows provides ongoing comfort with a compound growth rate of 11.4%. For example, Microsoft remains one of the best performing shares in the portfolio, up 26% year to date. In our view, Microsoft remains one of the few technology businesses that has managed to evolve and stay relevant in its market, and is in the midst of doing it again. We believe Microsoft remains attractively valued with a free cashflow yield of 10% and dividend yield of 2.9% as the market underestimates the growth prospects.WPP is a further example, as it continues to deliver robust performance. The proposed merger of its two biggest competitors, Omnicom and Publicis, sparked WPP to increase its focus on digital media and faster growing emerging markets, notably increasing its sales target. Capital allocation is also set to improve given the increase in the dividend payout ratio target from 40% to 45% over the next two years.
Companies with persistent returns, but receiving scepticism from the market – We maintain that quality is just as important as safety and safety just as important as price, making it crucial to consider strong durable franchises at attractive valuations. We have found that a strong franchise is a product or service that is able to resist the incursion of competition and consistently meet the needs of customers for decades. To us, businesses whose competitive advantage or franchise is dominated by intangible assets that will lead to high sustainable returns on capital and strong free cashflow are the definition of ‘quality’ companies. Our investment philosophy remains focused on low volatility, steady compounding of profits and consistent share price returns over time.

Column by Clyde Rossouw, Portfolio Manager, Investec Global Franchise strategy, Investec Asset Management

Vibrant Vietnam

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Vietnam Vibrante — Wikimedia CommonsPhoto: Daniel Schearf. Vibrant Vietnam

I recently made my first visit to Vietnam and spent several days in Ho Chi Minh City. Considered by the investment community to be a frontier market, Vietnam has a low per capita income (approximately US$1,600), a relatively young population and less mature capital markets. My research trips have taken me to many remote locations so I am generally prepared for poor infrastructure and chaotic environments. However, I found Ho Chi Minh’s Tan Son Nhat International Airport to be surprisingly efficient and modern, and the city’s roads are decent, if not better, than those in many other emerging or frontier Asian economies. The droves of motorcyclists and roadside food vendors, however, were a reminder that Vietnam is still in its early stages of economic development.

While many Asian countries generally do not have a strong coffee-drinking culture until incomes reach higher levels that induce lifestyle and consumption changes, Vietnamese coffee consumption is quite ubiquitous. There you can find a combination of both local coffee shop chains as well as foreign ones on virtually every bustling street. The popularity of coffee in Vietnam likely stems from the country’s French colonial influence, and the fact that Vietnam is a coffee producer sets it apart from the rest of Asia. Vietnam is actually the world’s second largest coffee producer behind Brazil with current annual output of approximately 1.5 million metric tons. Over 90% of coffee produced is exported, which makes coffee one of Vietnam’s most important commodities. I sampled some of the local coffee and I must say, Vietnamese coffee is quite strong and invigorating.

Another observation I made was the proliferation of not only small- to medium-sized, domestic branded coffee shops, but also jewelry and apparel stores, which could be somewhat of an indication of entrepreneurism in the local economy. In the past decade, the economic dominance of state-owned enterprises (SOEs) has shrunk due to ongoing reforms. The contribution to GDP growth from SOEs from 2001 to 2005 was about 33%. It dropped to 19% from 2006 to 2010, while GDP contributions from the private sector increased from about 45% to 54% in the same time period. Not surprisingly, the private sector now accounts for the bulk of Vietnam’s new job creation. However looking beyond these economic data points, I was heartened to see the vibrancy and drive of the local people on the ground. Not dissimilar to China’s pattern of economic development, Vietnam has been carrying out SOE reforms. Local entrepreneurs are now able to enjoy a higher degree of economic freedom, which should be favorable for Vietnam’s long-term economic development.

Lydia So, CFA, Portfolio Manager at Matthews Asia

Moving Down the Credit Spectrum

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From a top down perspective we expect spread compression to continue, i.e. a reduction in the yield that corporate bonds offer over corresponding risk-free bonds. This is likely to be driven by ‘lower for longer’ interest rates, especially in Europe where the European Central Bank appears to be taking a more dovish stance and diverging somewhat from the US Federal Reserve. Additionally, declining corporate bond supply in investment grade, particularly amongst financials, continues to create a demand for higher yielding assets further down the credit spectrum

Within high yield bonds – those that are rated sub-investment grade – Moody’s, the credit ratings agency, expects default rates to remain low. The global trailing 12-month default rate for sub-investment grade bonds was 2.8% for the year to October 2013 and Moody’s expects this to fall to 2.4% by October 2014. We share a similarly benign outlook for defaults within high yield and are therefore happy to move down the credit spectrum on a selective basis to pick up incremental spread/yield.

Taking into consideration the value within high yield bonds at the fundamental level, we prefer B/CCC credits relative to BBs for a number of reasons. First, they have fewer call constraints. What do we mean by this? Well, a lot of BB rated bonds are trading at prices that are close to, or in some cases above, the call price (the price at which the issuer has the option to redeem the bond). When an issuer calls in a bond it pays the bondholder the face value of the bond plus accrued interest, so when prevailing yields in the bond market for similar bonds fall below the rate on the callable bond, the issuer has an incentive to redeem the bond early and issue a new one. This can limit capital appreciation for the bondholder. In a world where yield is scarce we are keen to have greater control over the yields we receive.

Second, the issue sizes lower down the credit spectrum are typically much smaller at $200-300m. Since this is too small an issue size for the very large funds there tends to be fewer analysts following these bonds. This can create opportunities for those funds with strong analytical expertise to add value.

Third, there are fewer “tourist” investors in high yield such as exchange traded fund (ETFs) and investment grade funds. Again, this is often a reflection of the smaller size of the issues.

Finally, many of the B and CCC rated companies are new to the high yield market. They have effectively moved from bank loan to bond refinancing and so are less well known. This gives those asset managers with expertise in loans, such as Henderson, an advantage because the loans team who have already been analysing the companies can share their knowledge of a company ahead of a new high yield bond issue.

The above views are expressed within the Henderson Horizon Global High Yield Bond Fund, Henderson Horizon Euro High Yield Bond Fund, and Henderson Credit Alpha Fund, whilst within the investment grade Horizon Euro Corporate Bond Fund we have 8% of an available 20% off-benchmark allowance invested in high yield.

Opinion column by Thomas Ross, fixed income portfolio manager, Henderson Global Investors.

Risk of Stagflation Increases as Brazil’s Economy Shrinks

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Brazil’s economy contracted by 0.5% in the three months to September, down from a 1.8% expansion in the second quarter. This translates to a growth rate of 2.2% year-on-year, versus 3.3% growth in Q2. The Q3 GDP results were worse than consensusexpectations and are likely to deepen concerns of a possible debt rating downgrade for the sovereign.

The decline in output was led by the agricultural sector, which dropped from a 11.6% year-on-year expansion in Q2 to a contraction of 0.97% in Q3. Output from the manufacturing and construction sectors were also weaker, driving an overall decline in industry. On the expenditure side, consumer spending held up well, while investment and exports weakened, and imports climbed strongly.

 The figures are a worry for a number of reasons. Against a backdrop of a weaker currency, net exports should be increasing, not decreasing.Yet in contrast with India, the depreciation of the Brazilian real, occasioned by worries of quantitative easing tapering in the US, has not resulted in the macroeconomic adjustment we would expect. Secondly, the economy continues to be propped up by consumption and fiscal stimulus (government expenditures grew 2.3% year-on-year, up from 0.8% the previous quarter). But with a fiscal deficit of 3.2% of GDP anda consumer debt service ratio of 21%, the scope for this to continue seems limited.

The government risks a ratings downgrade, particularly nowthat revenues will be even lower-than-expected. Indeed, with elections in October, fiscal restraint appears unlikely, and so we expect a downgradewithin 12 months. Finally, the poor growth data increases pressure on the central bank to end its interest rate hiking cycle, despite an ongoing problem with high inflation and inflation expectations, which has been exacerbated by the weak real.

 There is no silver bullet for Brazil’s current mess. High inflation and weak growth limit the scope for loose fiscal or monetary policy as effectiveremedies. The medicine the economy needs most of all is structural reform to address the many supply side bottlenecks and to incentives newinvestment. Unfortunately, we suspect that action on this front is unlikely ahead of October’s elections. Growth should benefit somewhat froma recovery in developed markets next year, while inflation should ease on lower commodity prices. But if Brazil does not reduce its dependenceon consumption and fiscal populism, stagflation could become the norm, which the markets will punish.