The Fed’s landing gets softer

The big news of the week is inflation data for China and the US. In China there is deflation, which is a clear sign of a badly managed economy, both from a fiscal and a monetary perspective. While we have experienced high inflation here in the UK and elsewhere in the West, the spectre of deflation can be just as ruinous, and it does not suggest that the Chinese economy is recovering from its Covid re-opening. However, in contrast, US inflation for July was just the tonic for US stock markets that have been skittish of late. US headline inflation was weaker than expected, rising to 3.2% from 3% in June, but still less impacted by rising oil and gasoline prices than some expected. Core price growth, which is also closely watched to determine how embedded inflation has become, fell to 4.7% from 4.8% in June, and is at its lowest level since November 2021. Markets have reacted in a predictable way: stocks markets are slightly higher; the dollar is lower across the board and US 2-year Treasury yields were also down a touch to 4.77%.

The key driver of inflation, yet again, was shelter costs, although these are also driven higher by rising interest rates. Shelter costs were associated with 90% of the increase in July inflation data. While house prices and rental costs have been cooling of late, the improvement is yet to show through in the data, although economists are convinced that they will start to lower headline inflation in the US in the coming months. Economists believe that the CPI lags rental costs by roughly a year, since rental costs have only started to drop off, then we may not see the benefit in the broader inflation data until 2024. Airline fares had a negative impact on inflation, falling 8.1% on the month, with monthly declines in prices for used cars, electricity, and medical care services. However, although the headline rate ticked higher in July, this is also down to annual base effects, as prices in the US fell sharply in July 2022. Overall, it is clear the disinflationary trend is continuing in the US, and this makes a pause in rate hikes from the Federal Reserve highly likely in September. This should help stocks to cruise along in a tight, positive range for most of the rest of the month as the northern hemisphere enjoys the last weeks of summer.

When deflation goes wrong

However, while there is seemingly little to worry about in the US economy, there are problems elsewhere. China’s economy has slipped into deflation, which is ringing alarm bells for the global economy.  Negative price growth YoY in July, along with a drop in exports and accelerating youth unemployment is darkening the picture for China. In contrast to most of the Western world, prices for coal, steel and everyday essentials like vegetables and home appliances have been falling since China finally ended their 3-year zero covid policy. While headline inflation fell 0.3% YoY in July, core inflation rose to 0.8% YoY, which is the highest level since January. However, it’s too early to say if this will lead to falling inflation down the line. In the West, headline inflation led core inflation. If the same happens in China, then core inflation could also moderate in the coming months. The risk for the Chinese authorities is twofold: 1, if the expectation of falling prices becomes entrenched then consumers could put off buying goods and services, and 2, deflation is risky for a country with a high debt burden, since it will add to debt servicing costs for borrowers, which could also limit consumption.

So far, there has been no support to try and boost inflation in the economy, with authorities in Beijing saying that they expect prices to rise in the coming months. Added to this, China’s post- Covid predicament is unique: it has ample supply yet dormant demand, the exact opposite of what happened in the US and UK. China’s total debt is three times the size of its GDP, which is larger than the US. Thus, as the debt-fuelled inflationary bubble shrinks, it is unlikely to help reflate the Chinese economy. However, deflation in China could help to lower price pressures in the rest of the world, if one of the world’s largest consumers is tightening its belt.

Overall, China’s impact on the market is complicated, while one would think that the world’s second largest economy falling into deflation is negative for risk sentiment, this has not been the case, and stocks are trading higher so far this week. Instead, inflation figures are largely considered a domestic affair, and tend to hurt markets at home. However, the Shanghai Composite market is flat on the week, and is up 1.35% on the month. Added to this, the impact of the White House’s latest restrictions on outbound investment into the Chinese tech sector is not impacting the world’s tech sector, perhaps because there is so much momentum in the US economy. Added to this, French luxury goods giant LVMH is up more than 3% on Thursday after news that Beijing will allow group tours to travel again, which is building hopes that this will include lavish shopping sprees all over the West. Overall, the market can take a rest in August, for now, no one is worrying about anything too much, which is just about right for the last weeks of summer.