Posted 23 January 2023
Overview: Slowing growth throws markets into a bind
The upbeat start to the year, where markets kept rising – because bad economic news was actually good news in terms of lessening concerns over future interest rate rises – had to end sooner or later. Sure enough, over the course of last week, various economic data releases in the US painted a clearer picture of a slowing economy, from declining Christmas retail sales to industrial production. Even though this pushed long-term bond yields down further, and had longer term inflation expectations decline to a very benign 2%, this time markets took the bad news negatively, giving back some of the gains of the previous week.
This tells us that markets may well have run out of positive momentum, and that it will be a tough ask for US markets to push higher on the back of receding rate rise fears only. In Europe and even the UK on the other hand, where macroeconomic data continues to come out ‘not as bad as feared’ but with price inflation also receding, stock markets had a much better week, even if the FTSE100 has still not managed to close above its all-time high it has neared over the past two weeks.
There was better news globally. China said it was past the peak in Covid-related hospitalisations. Hong Kong authorities are even telling people with asymptomatic Covid infections to return to work. Ahead of this week’s Lunar New Year celebrations, travel has picked up to near normal levels. More and more research houses are pointing towards the likelihood that China’s re-opening will deliver a similar growth surge as the western world experienced in the spring of 2021, except with even more pent-up demand and cumulative savings in the hands of consumers after three years of harshly restricted public life.
PPI pullback and the ‘new normal’ for inflation
Judging by capital market expectations, we are over the inflation hump, and price increases are now expected to trend downward in the US, UK and Europe. US Treasury yields have fallen consistently since the beginning of November and are now back to where they were in September – just before the world had a UK-inspired bond rodeo. This implies lower growth and price expectations in the years ahead, and comes on the back of a 6.5% December annual inflation reading in the US – its lowest in more than a year. Lower inflation readings are backed up by both easing supply constraints and notably weaker demand. Global demand has slowed substantially, easing public pressure on central banks to bring demand-driven inflation down.
Of particular note then, is the fall in producer price inflation (PPI). While it mirrors and starts with commodity price changes, it also more tightly reflects businesses’ waning pricing power across the whole value chain. It is therefore seen as a good indicator of the supply-demand balance. PPI has been trending consistently down in most regions – particularly Europe – for the last few months. The one exception is China which, after years of repeated lockdowns, finds itself only at the very beginning of the same recovery cycle that pushed up prices in other regions since the spring of 2021. All the same, Chinese PPI is starting from a much weaker position, deeply negative.
Central banks still seem committed to tightening policy, in spite of a weakening economy. Nevertheless, these PPI figures point to a very different scenario. Far from entrenched inflation, it looks like the US backdrop became disinflationary around September, and has stayed that way into the new year. In that time, global demand and price pressures have eased greatly. Energy prices – particularly for wholesale natural gas – have fallen substantially since November on the back of a much warmer winter than expected. Even Bank of England governor Andrew Bailey – a committed hawk in the global inflation fight – has admitted this makes the job much easier. He is now optimistic about an “easier path” out of inflation pressures.
While capital markets are buying into this optimism, not everyone is convinced. There is an emerging view that the old regime of 2% average inflation is gone, and will be replaced by an average much closer to 4-5% over the long-term. This is reportedly a view shared by many of the movers and shakers at the World Economic Forum in Davos, and it backs up commentary we are seeing quite widely in the financial media. The thought is that, due to structural changes in the global economy, central banks will no longer feasibly be able to target 2% inflation and will have to adjust their targets higher. This will mean structurally higher interest rates too – a far cry from what we saw in the period between the global financial crisis and the pandemic.
We can only point out that moving to a regime of 4% annual inflation is not a simple matter. Inflation disproportionately affects lower income earners by destroying their purchasing power. To counteract this, the economy has to give disproportionate wage increases to the less well-off, or else inequality grows dramatically, with potentially disastrous political consequences. Investors have to understand how a 4-5% annual inflation regime has the potential to eat into available capital returns – unless compensating productivity increases plug the hole. Davos attendees should be careful what they wish for.
Monetary easing in Japan: endgame or dawn of a new era?
Japan’s bond market is faltering. Bank of Japan (BoJ) Governor Haruhiko Kuroda, nearly at the end of his ten-year tenure, is committed to controlling the yield curve in his aim to stimulate the economy. But bond traders doubt he or his successor will be able to. The result has been selling pressure on Japanese government bonds (JGBs), and the BoJ having to hoover up those sales to maintain its target. The fallout has affected currency and equity markets, creating a notable tightening of Japan’s financial conditions.
The BoJ’s monetary policy approach of yield curve control – began by Kuroda in 2016 – is unlike any other central bank. Instead of committing to buying a fixed number of government bonds, the BoJ sets a yield target (currently at 0%) and will buy any amount of bonds necessary to meet it, with some fluctuation around the target. Yield curve control (YCC) has always had its doubters, but the policy worked surprisingly well for years, due to markets’ belief about the credibility of the BoJ’s promise and the stability of Japan’s economy. But cracks appeared last year, as sharply higher interest rates in the US made JGBs less attractive. Investors sold yen assets – many back to the BoJ – putting massive downward pressure on the currency. The surge in global prices meant inflation had finally come to Japan too, leading to speculation that YCC would be abandoned. Bond traders thought this was all but confirmed in December, when the BoJ suddenly announced it would tolerate a 0.5% rise in ten-year JGB yields.
However, last week Kuroda used his penultimate meeting in charge to quash those expectations. No changes were announced, keeping interest rates at -0.1% and the ten-year yield target at 0%. The decision “sets the BoJ up for a protracted battle with the market,” according to a Tokyo-based JPMorgan strategist. The BoJ’s longest-serving governor is sticking to his guns, but his successor might struggle to show the same resolve. Traders expect great selling pressure and a difficult decision ahead. Whoever takes over from Kuroda will undoubtedly share his dovish philosophy, wanting to keep financial conditions easy and maintain the YCC if possible. But markets will no doubt test the BoJ’s resolve with renewed selling pressure on JGBs. The BoJ already owns more than half of the outstanding JGBs – an unprecedented footprint for any central bank. The closer that percentage share gets to a hundred, the more questions will be asked about the viability of YCC.