The goods inflation warning

Good morning. We hate sounding so downbeat all the time. Yesterday, it was FIS embarrassing capitalism. Today, it’s sour inflation news. Maybe tomorrow we’ll write a list of good news in markets. Send us your candidates: robert.armstrong@ft.com and ethan.wu@ft.com. 

Sifting through a noisy inflation report

Sometimes markets get caught unprepared by new data. Not yesterday. Most experts expected inflation would reaccelerate a bit, and it did, with the core consumer price index rising to an annualised 5.1 per cent in January, up from 4.9 per cent in December. Hot-and-sticky shelter inflation looked basically unchanged. Markets were ready for it all; after falling initially, the S&P 500 ended the day flat. Two-year yields rose a modest 9 basis points.

Inflation data is always noisy, but especially so this month. The Bureau of Labor Statistics made two annual methodology adjustments that analysts believe were slightly inflationary. Most years, CPI exhibits what Manuel Abecasis and Spencer Hill of Goldman Sachs call the “January effect”, as year-start price increases push up the index beyond what seasonal adjustment accounts for. This year, they think, the January effect interacted with pent-up cost inflation, possibly explaining startling price increases in certain categories.

In other words, if you need reasons to dismiss this inflation report, a few are available. Nevertheless, there are two important warnings in the numbers, which the Federal Reserve seems likely to heed.

The first is that core goods prices — which had been falling for three months — picked back up in January, rising 0.1 per cent. The chart below uses moving averages to smooth over monthly changes but look at the tick-up in the blue line:

Some analysts dismissed the change, and not unreasonably. One might suspect the January effect behind outsized price increases in, for example, prescription drugs (up 2.1 per cent in one month), furnishings and clothes. Andrew Hunter of Capital Economics wrote that “with the surveys continuing to suggest that global goods supply chain shortages are fading rapidly, we still think renewed falls in core goods prices lie ahead”.

But blip or not, it raises the question: how reliable is core goods deflation? There are reasons for worry. Wholesale used car data no longer has prices in freefall, while some data even shows outright increases. Omair Sharif at Inflation Insights thinks the used-car CPI sub-index could start increasing as soon as March, eliminating one of the strongest and most consistent inflation drags. Maybe this is noise, but the clear-as-day deflationary story in goods is wobbling.

The second warning is that services inflation isn’t budging. Happily, it isn’t shooting up, either. But progress is coming at an achingly slow pace (chart from Pantheon Macroeconomics):

Summing up, then, here is a regular check-in on Jay Powell’s three conditions for easing monetary policy:

• Core goods prices need to keep falling. This still looks like it’s happening, though we’re marginally less sure now.

• Housing inflation needs to follow private rent indices down, as is expected later this year. Still too early to tell.

• Ex-housing core services inflation needs to fall decisively. Falling, yes; decisively, no.

It is doubtful that a data-dependent Fed will look at this list and conclude that its job is done. Following the CPI report, several investment banks, including Barclays and Deutsche, lifted their estimates of the peak policy rate to the mid-5s. If inflation progress remains OK but not great, more increases will follow. (Ethan Wu)

The China reopening trade, revisited

The last time we looked in on the China reopening trade, about a month ago, we made four basic points:

1. There is significant pent-up demand and savings in China if the post-zero-Covid reopening goes smoothly.

2. Chinese stocks are cheap, both in absolute terms (about 11 times forward earnings for the MSCI China index) and relative ones (they have fallen behind the emerging market indices they usually track).

3. But the path of the reopening is uncertain; no one has proven very good at predicting the path of the virus.

4. The trajectory of reopening policy is uncertain, too; no one has proven very good at predicting the action of the Communist party in this area.

The bullishness of the first two points was counterbalanced, in our estimation, by the bearishness of the second two. We concluded that “11 times forward earnings seems not so much cheap as fair”.

The MSCI China index is down 2 per cent since we wrote that and mainland stocks are up only slightly, which may seem to confirm our instincts. Perhaps the reopening trade simply became crowded. The soft performance may also have a lot to do with the risk-off sentiment that has prevailed in global markets in the past few weeks, as US interest rate expectations have risen.

The economic fundamentals of the reopening story, by contrast, look solid. In a recent note, Pantheon Macroeconomics’ chief China economist, Duncan Wrigley, noted that over the Chinese new year holiday, value added tax receipts in consumption sectors were 12 per cent higher than the 2019 holiday level; cinema sales were 14 per cent above the 2019 level; and domestic tourism trips rose to 89 per cent of the 2019 level. Inflation has remained mostly under control. Both retail sales growth and residential property sales growth ticked up (albeit slowly and from a low level) in December.

The risks associated with reopening are becoming less daunting. And investors are taking notice. This is from a Wall Street Journal story yesterday:

Investors have added more than $2bn on a net basis this year to US-based mutual and exchange traded funds that buy Chinese equities, according to data from Refinitiv Lipper. That reflects five consecutive weeks of inflows and marks a reversal from the second half of last year when they pulled almost $1bn.

A similar story ran in the Financial Times (a week earlier, of course). It focused on the buying of mainland shares:

Global investors have snapped up a record $21bn worth of Chinese equities this year, as robust economic data spurs traders to make larger bets that the reopening rally has further to run.

Foreign buying of Shanghai- and Shenzhen-listed shares through Hong Kong’s Stock Connect programme has rocketed to Rmb141bn ($21bn) so far in 2023 — more than double the previous record for the same period in 2021 . . . 

“When everybody said they’d like to have a portfolio without China, that was the bottom,” said Alison Shimada at Allspring Global Investments. She said that Allspring was now “a little overweight” on Chinese equities after increasing its allocation on October 31 — a view that was “not popular at the time”.

Mainland stocks are up 27 per cent in dollar terms since global sentiment about, and flows into, China bottomed at the end of October. Shares in Hong Kong are up 44 per cent. The surge in global flows and its effect on prices has forced us to consider whether our view of China is missing a crucial element. We have focused on three factors: valuations, growth rates and regulatory risk. We have been particularly jumpy about regulatory risk because we don’t know how to quantify it. But maybe we are missing a simple part of the bull case. There is a huge amount of investable capital in the world looking for a home, and the world as a whole remains underweight China, particularly mainland shares. It might take only small improvements in the regulatory climate, and only slightly above average economic growth relative to the rest of the world, for the ownership imbalance to normalise over time and Chinese valuations to get a lift.

JPMorgan Asset Management notes that almost two-thirds of investors with global benchmarks have no mainland China share exposure; a third of emerging market investors have no exposure. The Chinese economy is three-quarters the size of the US’s, but its stock markets are less than 40 per cent the size of America’s. This could be an important tailwind for investors in China, if the Communist party can stay mostly out of the way.

One good read

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