Monday Digest

Posted 20 May 2024

Pluses and minuses

Global stocks edged higher last week, led by the US. The S&P 500’s slight gain was enough to push it to all-time highs, making a fairly average week seem like a great one. US equities were propelled by April’s 3.4% inflation figure -the first time CPI didn’t come in higher than expected this year. Markets have become so used to the US economy beating expectations that it feels like an achievement when things are as predicted.

We shouldn’t get too excited about US inflation. Producer prices beat expectations again, suggesting further inflation might be in store. This matches signals from consumer demand and strong corporate profits too. It is a conundrum for markets and the Federal Reserve, which is still signalling interest rate cuts despite continued strength.

Cuts look a sure thing this side of the Atlantic, with lower inflation and weaker growth prospects. But it remains to be seen how deep or fast the Bank of England and European Central Bank’s cuts will be. ECB board member Schnabel warned on Friday that, if the ECB slashes next month as expected, back-to-back moves are unlikely.

BoE dovishness has helped support a strong period for UK stocks, even though the US and Europe still have the upper hand year-to-date. UK investors should bear in mind that portfolio values don’t exactly track the FTSE 100 – which has undeniably been a good thing over the long-term. UK stocks used to be a fairly good barometer of global equity, but have become extremely focused on a few sectors in recent years, so are no longer a great yardstick.

The US’ tariff increase on Chinese electric vehicles and solar panels was one of the week’s most prominent stories. The actual economic effect will probably be small, but it shows continued tension between the world’s two largest economies. EU policymakers are currently staying out of it, but that could change if US tariffs lead to more Chinese ‘dumping’ on the global market.

Markets’ middling week reflects these mixed signals. At least portfolio values are at new all-time highs too.

Inflation targeting: why 2%?

Markets were excited about lower US inflation last week, but headline and core numbers remain comfortably above the Federal Reserve’s official 2% target. But the Fed seems keen to press ahead with interest rate cuts regardless.

This has made people question whether the 2% inflation target – adopted by nearly 60 countries – is even the right one. Many think that 2% medium-term inflation is unrealistic, given global macroeconomic trends of deglobalisation, decarbonisation and hangover from the pandemic. Even if it is achievable, is 2% inflation desirable?

In truth, the 2% target is a bit arbitrary. It started from an offhand comment by New Zealand’s finance minister in 1988, from which the central bank crunched a few numbers and started targeting 2% inflation. It seemed to work, so Canada adopted the same target a few years later. The Bank of England adopted an official 1-4% target range after leaving the ERM, which got shifted to 2% and legally enshrined after BoE independence. The BoE governor has to write to the chancellor if inflation strays 1% or more from the target, but the bank’s only explanation for the 2% target is that the government says so. The Fed didn’t even officially adopt a 2% inflation target until 2012.

Some argue that central banks don’t need a specific target. Paul Volcker famously crushed an inflation crisis in the 1980s without a specific target in mind, and the Fed, ECB and BoE have already loosened their own interpretations of a 2% target, with talk of long-term averages and “symmetric” targets. And even if we think inflation should have a target, there is little evidence to say 2% is the right one. IMF chief economist Olivier Blanchard thinks 3-4% is more appropriate, for example.

That being said, the worry is that changing the target now would undermine central banks’ credibility. They are already accused of being ‘behind the curve’ for the current inflation crisis, and changing the target now might look like throwing in the towel. The 2% target might be loosened when this is all over, but don’t expect pronouncements yet.

China building a new world order, but still living in this one

Vladimir Putin was in China this week, strengthening the “no limits” Russian-Chinese friendship. Economic ties between the two nations are now huge, totalling $240bn in bilateral trade last year. China’s trade with the US – an economy nearly 14 times as big as Russia – was $575bn in 2023. In an interview with Xinhua news, Putin beamed: “Today, Russia-China relations have reached the highest level ever, and despite the difficult global situation continue to get stronger.”

Both Putin and President Xi want to challenge US international supremacy, and China now claims to be the largest trading partner of over 120 countries. The country’s drive to create a multipolar world has accelerated in recent years out of necessity, with President Biden expanding the US-China trade wars launched by Donald Trump. On Tuesday, the White House quadrupled tariffs on Chinese electric vehicles, the latest move in a tit-for-tat that has knocked China from the top spot among US trading partners.

But China’s new world order doesn’t mean it has given up on the current one. Beijing launched a case against the US at the WTO in March and has unveiled multiple measures to lure western investors and businesses over the last year. Much of this is out of necessity, with the economy still ailing from domestic demand weakness and Beijing unveiling support measures to turn it around.

Interestingly, currency devaluation has not been one of those measures, despite historical precedence. Keeping the renminbi stable is necessary for attracting foreign investment, but it remains to be seen how much longer the People’s Bank of China can support its currency.

Beijing wants to create a new world order, but it has to live in this one. That is why we will probably see more policy signals that might look inconsistent – like buddying with Russia while trying to appease western investors. It makes China a curious investment proposition. The recent stock market rally shows that Chinese assets can be good for diversification, but politics pose unique risks.