Posted 20 November 2023
Overview: Inflation genie back in the bottle?
Last week was another good one for most investors. In sterling terms, the strongest equity markets were in Europe with the DAX up 4.5% over the week, the biggest winners being small and mid-sized firms. Risk asset markets are benefitting from the perception that central banks have reached their tightest levels in terms of interest rates and that from here, rates will move lower. That perception grew stronger last week. Yields on 10-year government bonds were down another 0.2%-0.3% in the UK, Europe and the US, and the move was even stronger for shorter-dated maturities.
Thinking we are through the worst is tempting, but is also dangerous. Indeed, central banks moving from tightening policy to easing is also a sign that economic growth is not going so well. And if growth is not going so well, profits may be under pressure. We have one more set of 2023 central bank meetings in December. Investors have been positive about prospects of dovish announcements, but we will need to hear that it’s more than okay to talk about rate cuts – which was certainly opposite to what central bankers stressed earlier in the month.
Lastly, the US dollar has weakened as the US growth exceptionalism appears to be running out. We think that this has the makings of an important shift, one which could be important for longer-term economic and investment outcomes. We will cover this in more detail in our 2024 outlook, which we will publish in mid-December.
Why fragile growth is now the key concern
One year ago, high levels of inflation were the greatest anxiety for investors and policymakers. For much of this year, the pace of price rises has declined but in order to achieve this, central banks have raised interest rates to cool down demand and so the world’s economy has slowed. That slowing has done its job, with an increasing impact on inflation. Now though, the fragility of global growth is a greater concern for investors than the possibility of another bounce in inflation.
We know that if policymakers want to guide demand in their economies, they face a very difficult task. If economies continue to drift below potential and the pace of inflation continues to move down in developed nations, ‘higher’ won’t be for ‘longer’. However, we would remind everyone that not taking monetary policymakers at their words has been a losing game all year long. Caution should particularly be taken with the US Federal Reserve (Fed). The Fed is in many ways the leader of the ‘higher for longer’ chorus, because the US economy is leading the developed world. According to JP Morgan’s nowcast, for example, US growth dipped only mildly below potential into the end of 2022, then bounced back to record a blistering 4.9% seasonally adjusted annual rate from July to September, obviously above potential. Over only a few weeks, growth has now shifted back below a 2% potential estimate. Unemployment has risen slightly to 3.9%, but is still below the Fed’s 4.5% estimate of employment balance.
So, while there is some logic to expecting rate cuts from the BoE and ECB, expecting them from the Fed – as many now are – looks riskier. Moreover, the whole picture is complicated by the fact that developed world central bankers take their cues from each – and so often particularly from the Fed. It may take yet more weakness and fragility to really change their minds.
China begins to realise its potential
For western investors, China has been the biggest disappointment of the year. A post-Covid boom looked like a sure thing 12 months ago, but economic activity has been lacklustre, held back by an ailing property sector and weak domestic demand. While most developed economies have struggled to contain sky-high inflation, China has been flirting with deflation all through 2023. Accordingly, the stock market rally into the end of last year has well and truly unravelled. A consistent slide from January leaves mainland China’s benchmark CSI 300 index barely above where it was in October 2022 – its lowest point during the entire pandemic.
However, things could be turning in the world’s second-largest economy. Chinese consumer demand and industrial activity both came in stronger than economists expected in October. Retail sales showed 7.6% year-on-year growth last month, beating expectations of 7% and comfortably above the 5.5% figure from September. Industrial production was more muted but showed marginal improvement on the month before, 4.6% for October versus 4.5% for September – and was the sector’s strongest return since April. Just as encouraging is a potentially powerful fiscal boost. According to Bloomberg, Beijing is considering giving up to RMB 1 trillion for urban village redevelopment – most likely through its pledged supplementary lending (PSL). The throwback to 2015 policy – the zenith of Beijing’s credit-growth model – is likely in part to appease those nostalgic for the good old days.
Beijing excited markets last year when it hinted at monetary and fiscal easing – supposedly aimed at stressed property developers – but actual measures were relatively moderate and a far cry from previous episodes, most notably in 2015, when Xi Jinping’s government wielded its policy ‘bazooka’ to turbocharge the economy. And yet, last week we saw the clearest signs of increased firepower as the People’s Bank of China (PBoC) gave out RMB 1.45 trillion through its medium-term lending facility, the central bank’s biggest splurge since the heady days of 2016. Repeating old policy does not guarantee the same results, of course, but it is possible that liquidity injections from the PBoC could help to enable markets to connect to an improving economy.
The government is clearly alive to how weak China’s economy has been, and will know that rebuilding confidence will take time. Chinese companies have endured a long period of selling and, in some cases, have already lost much of their foreign-linked backing. This is no doubt one of the reasons for President Xi’s conciliatory approach to the US, exemplified by meeting President Biden in San Francisco last week. While concrete policies rarely come from such high-level meetings, it is an undeniable show of China’s willingness to normalise US relations after the tensions of the last few years. What that means for the Chinese, American and global economies depends on whether Washington feels the same.