Monday Digest

Posted 25 March 2024

Stick to the Plan

Brighter days for markets; returns were strong across the board last week, thanks to central bank messaging.

The Bank of England (BoE) “has done its job” according to Governor Bailey, and “we are not seeing a lot of sticky persistence” in inflation. Markets are pricing cuts in July, with rates settling at 3.5% in 24 months. If the BoE moves rates in line with economic activity, though, it would mean rates between 3% and 3.5% in around 18 months on our calculations.

The hawkish Monetary Policy Committee members are less hawkish now that inflationary behaviour has dissipated. Recent data shows more money is being spent, but the rise is slow. It vindicates the BoE’s wait-and-see approach. Comments suggest MPC members now fear low growth more than inflation, which could mean a rate cut in May if April inflation is lower than 2%, as expected.

The ECB could join in, after telling us that “rate cuts are coming”. Manufacturing confidence is low, and Switzerland cut rates during the week, supporting the notion of an ECB cut. The Bank of Japan actually raised rates, but markets acted like they cut (see article below). There was weakness in China – the heart of global disinflation – which led to falling Chinese bond yields and possible policy giveaways from Beijing.

The Federal Reserve said it was still expecting to cut rates, despite US inflation picking up. There is a growing confidence that the US economy is balanced, despite continued economic strength. But strength is a complication for chairman Powell’s plan. The Fed expects 2.1% real growth and 2.4% inflation in 2024, but things will have to slow from here to achieve that – and current activity is rising.

Central banks feel vindicated in sticking to their plans: inflation is down and activity is not too bad. For the Fed specifically, this might be overconfidence, but that will be good for company profits in the short-term. Our only worry is that, if inflation does move higher, the nice rate cut narrative might shift suddenly.

Japan’s rates are go – and markets up with them

The Bank of Japan (BoJ) raised interest rates for the first time in 17 years last week. The hike, from -0.1% to a range between 0% and +0.1% might seem tiny, but it is big and symbolic for the Japanese. The BoJ becomes the last central bank to end negative rates, curtailing the era of no payouts for Japanese depositors.

Markets reacted unintuitively. The value of the yen fell sharply, the currency now at ¥151 on the dollar. Bond yields also fell, with Japanese 10-year yields now well below the 1% peak from October. Equities rallied too, and the Nikkei 225 up over 20% year-to-date. All of these are the reverse of what you would expect when Japan’s monetary policy is finally tightening.

Markets acted like the BoJ cut rates instead of hiked them, because the decision came with dovish signals. Japanese inflation is now barely above the bank’s 2% target and trending down, so BoJ governor Kazuo Ueda has said borrowing costs will not go up sharply. Market positivity – which pushed the Nikkei past its 1989 asset bubble peak only last month – should help stave off a return to deflation.

Japan’s goods, services and labour are extremely competitive after decades of stagnation. There have been corporate structural changes in the last decade which will help take advantage of that too – resulting in the biggest wage increase since 1992. Structural changes, the third arrow of the late Prime Minister Shinzo Abe’s “Abenomics”, have finally hit home. This will likely mean stronger inflation and nominal growth, even if still low compared to the world.

Thankfully, the BoJ is keeping rates low relative to the expected growth, with real (inflation-adjusted) rates still negative. It refuses to do much in the face of inflation, and Japan’s economy should benefit.

Neom and the Saudi Line

Saudi Arabia wants to create the future of sustainable living in Neom, a futuristic megacity featuring “The Line”, a linear ‘smart city’ with no cars or fossil fuels. There is understandable cynicism in the West, considering the country is the world’s largest oil exporter and currently imports 80% of its food. Critics have called it “greenwashing” or purely PR, similar to Saudis’ extensive sports investments.

But at a top estimated cost of $1 trillion ($500bn on the low end), Neom would be by far the most expensive publicity stunt in history. There are more cost effective ways of improving image that Riyadh is already pursuing – like forcing international companies to set up Saudi headquarters or joint ventures in exchange for government deals. Many big names have already done so, and more are sure to follow.

The huge sums and coordinated policies tell us Crown Prince Mohammed bin Salman is serious about diversifying the Kingdom away from oil exports. It obviously has an interest in promoting oil, but the nation’s long-term interests are to no longer rely on the industry.

Part of the ‘Saudi Vision 2030’ campaign is about aligning Saudi Arabia – which has a higher GDP per capita than several European nations – with global economic and financial institutions. Its links to the global economy are currently one-track, and there are opportunities in diversifying them.

That requires upfront capital, and Riyadh is certainly willing to spend it. Not only might the Kingdom’s massive reserves be put to work for global companies, but the domestic stock market – including the world’s most profitable company Saudi Aramco – might be opened up too. It means a reallocation of capital towards newer, hopefully productive, areas. Opportunities are there, but risks of congestion and misallocation are too.

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