Financial update from Brewin Dolphin - 11 August 2023
The Weekly Round-up
Friday 11 August 2023
In his latest weekly round-up, Guy Foster, our Chief Strategist, analyses disappointing economic data from China and the latest US inflation numbers.
This was another week in which the deflationary narrative was generally supported by news flow. As we have discussed in previous weeks, the concerns over inflation in China have centred upon it being too low rather than too high. This week saw more disappointing data to bolster the bearish outlook although, as ever, there is some nuance to it.
Looking at China first, the economic data has been grim lately. Property remains a key area of weakness. House prices continue to contract, with the backdrop for existing homes particularly poor. Meanwhile, there has been a decline in home sales by floor area, with the contraction significantly worse than the downturn that took place in 2014.
Linked to this, the carnage among property developers continues. Country Garden, which used to be the biggest developer in China by sales, has seen its bond that matures early next year drop to a new low after it failed to make a dollar bond payment on Monday. Given its high exposure to tier 3 cities, where the backdrop is particularly challenging, it seems like only a matter of time before it joins the growing list of Chinese developers who have already defaulted.
Tuesday’s trade data deepened the woe. China reported a deepening contraction in exports, which reflects the slowdown in global goods consumption. This year was, however, supposed to be the year that China bucked that global trend by springing from Covid-zero with a resurgence in domestic demand. The continued contraction in imports announced this week joins a growing list of indicators that highlight domestic demand is faltering.
China, it is argued, could be suffering from a particular kind of slowdown which has stymied other economies – such as the US after the financial crisis or, more relevantly, Japan after the bursting of its real estate bubble. The argument is that when the value of household assets starts to fall, it encourages households to try to bolster their wealth through saving. That can make conventional policy measures to support growth ineffective.
The risk is that this ends up in a deflationary trap. This week’s Chinese inflation data showed that consumer prices began to contract on an annual basis for the first time this cycle, following in the footsteps of producer prices which have been falling for several months. All this comes at a time when, unlike most of the rest of the world, monetary policy has been getting looser. China has been cutting interest rates but, in keeping with the deflationary trap narrative, Chinese activity has continued to slow which has added to the fears that monetary policy in China is ‘pushing on a string’.
Without sugar-coating economic developments in China, digging beneath the surface, things are probably slightly less bad than they appear at first glance. Part of the reason that import values were so weak is due to the decline in commodity prices over the past year, which pulled Chinese import prices lower.
Local governments have been told to exhaust their special bond issuance quotas, which are used to finance infrastructure, by the end of September. This should add some support to commodity prices. It is also worth bearing in mind that the peak in global commodity prices was last June. As time passes, the base effect of commodity prices pushing year-on-year inflation in China lower should diminish.
Turning to the negative headline consumer price index (CPI), a good chunk of that was due to the plunge in food prices. Food prices are volatile and carry a relatively high 20% weight in the Chinese CPI. July 2022 saw a 25% increase in pork prices, which were flat in July 2023. That alone was a considerable drag on CPI and has little to do with domestic demand. Importantly, core CPI picked up to its fastest pace this year. The single month of July was actually one of the strongest for core prices on record. Inflation in the stickier services category hit the highest level in 17 months.
The crisis among property developers has been going on for a couple years now, and unfortunately there aren’t indications that it will be resolved anytime soon. The government’s options include bailing out failing developers, allowing them to fail and be resolved by creditors, or some sort of managed restructuring which falls between the two. So far, that is the route it has taken to avoid inflicting further short-term pain on the economy. That means continued credit support for developers and financial help to complete projects. The authorities will also likely continue to prioritise protecting Chinese households, who have bought unfinished apartments, suppliers, construction workers, and small local investors.
Chinese shares have remained weak, though, as uncertainty over future policy remains a crippling threat for investors. This morning it was announced that local authorities would be permitted to borrow in order to assume the debts of local government financing vehicles which have financed lots of real estate construction but now seem financially precarious. This should have been greeted positively but for the de minimis size of the programme. Investors are concerned that the Chinese Communist Party will act too slowly to address China’s woes – fears which were compounded by this morning’s announcement of a sharp contraction in credit circulating in China during July.
A rosier picture in the US
If Chinese president Xi Jinping thought China’s travails would attract any sympathy from his US counterpart, he was mistaken. President Joe Biden was reported as being highly critical of China and its policies as the weak economic data was rolling in.
As discussed, the decline in US inflation has been one of the best pieces of news for investors over the last five months or so. This month ostensibly saw that come to an end, with the headline inflation rate rising amid an increase in energy prices. Energy is the most volatile major CPI category and tends to dominate the headline inflation rate. It is also one of the components which can be least reflective of domestic demand conditions. For this reason, the focus tends to be on core inflation, which is more reflective of domestic conditions.
In July, US core CPI rose by 0.2%, which is a level consistent with the Federal Reserve hitting its personal consumption expenditures (PCE) inflation target. It was the first time since early 2021 that the core CPI increased by this magnitude or less for two straight months. Core services ex-shelter inflation is closely watched, as this is the category believed to be most impacted by labour market conditions, which remain tight. It ticked up from the previous month, but only to 0.2%, so the Fed will be happy with that number as well.
Durable goods CPI was negative for the second straight month, helped by price declines in the used vehicle category, which should continue into the August report. This, combined with the general moderation in goods demand and repaired supply chains, should help keep durable goods inflation in check. But the decline in the trade weighted dollar index over the past year implies that the US will no longer be able to count on a continued decline in import prices to reduce goods inflation. Despite the weak dollar, food CPI should continue to moderate in the coming months.
Nothing in economics happens in isolation. If headline inflation resumes its decline, that should help push up real wages, which will support economic activity. It’s also worth noting that the expected five-year inflation rate, five years into the future, which the Fed monitors to test inflation expectations, has been rising. These factors may make it less confident about the benign inflation trend continuing.
In summary, the July CPI report likely leaves the Fed on track to hold rates steady at its September meeting. But it’s too early to rule out another rate hike later this year.
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