While inflation is causing a headache, there are other factors that could add up to a serious market migraine. Russia’s temporary withdrawal from the UN-backed initiative to allow Ukrainian grain shipments highlights the scope for disruption to commodity supplies. As long as the conflict continues, energy supply uncertainty remains, especially in Europe. Covid cases in China are rising again, which could mean more lockdowns and supply-chain disruption. There is also policy uncertainty in the UK and rising political tensions between China and the US.
Different inflation dynamics
While inflation is a global phenomenon in many ways, not all inflation is the same. In the eurozone, headline inflation surged to a record high of 10.7% in October, while core inflation, excluding the more volatile food and energy components, rose by 5%, less than half the headline number. In the US, however, it is core services inflation – 80% of the total – that is the bigger problem.
For comparison, the latest data for the US headline consumer price index (CPI) showed inflation running at 8.2%, but core inflation at 6.7% (81% of headline inflation). Crucially, the US Federal Reserve’s (Fed) preferred inflation metric, the core personal consumption expenditures (PCE) index, now stands at 5.1%, still more than double the Fed’s 2% target (see Exhibit 1).
With the energy crunch driving much of Europe’s inflation, the continent is facing a significantly higher risk of stagflation. The US is relatively sheltered from the energy crisis because it is self-sufficient in gas and produces much of the oil and other energy it needs.
The upside surprise in US core inflation reflects the strength of aggregate domestic demand. US CPI shelter costs, which make up 30% of the overall US inflation index and 40% of core CPI, are expected to remain high in the near term. Typically, this component of inflation is driven by labour market strength, vacancy rates and home affordability.
The Fed’s concern is that high core inflation might lead to an un-anchoring of inflation expectations.
Across Europe, surging energy and food price inflation is eroding real incomes significantly. A recent survey by the European Central Bank (ECB) showed that consumers’ inflation expectations were still rising throughout the region. Like the Fed, the ECB’s major worry is that rising inflation expectations among consumers create the potential for self-reinforcing inflation.
Over the last week, the Fed and the ECB have both raised policy rates by 75 basis points, as expected. Previously, the Bank of Canada (BoC) had raised its benchmark rate by a lower-than-expected 50bp.
The ECB’s statement after the rate decision was less hawkish than in September, with President Lagarde saying the scale and pace of future rate rises would depend on the outlook for inflation and take into account the typical delay before the impact from previous rate increases on inflation was revealed.
Some analysts suggest that the BoC’s contained rate move, the ECB’s less hawkish tone and signs of a policy debate within the Fed on slowing the pace of rate rises might point to central banks shifting soon towards a less aggressive policy stance in the face of economic weakness.
Indeed, while exports propelled US real GDP to grow by an annualised 2.6% in the third quarter after two consecutive quarters of decline, private final demand stalled, imports fell and housing starts and new home sales fell further.
We think any policy pivot expectations are premature. Speaking on 2 November, after the Federal Open Markets Committee (FOMC) increased its main fed funds rate by 75bp for the fourth time in a row, Fed Chair Powell said “data since our last meeting suggests the ultimate level of interest rates will be higher than expected.”
Markets reacted promptly, bidding up their estimates of future fed funds rates. Their expectation of the peak, probably reached by May 2023, is for the first time above 5%, well ahead the 4.6% mentioned at the September meeting of the FOMC. The pace of rate increases may slow, but a reversal is not in sight.
Volatility in the UK…
Policy uncertainty lingers as new PM Rishi Sunak’s assurance of financial discipline, which means fiscal austerity, could push the country quicker and deeper into recession. Investors have been avoiding UK assets: A Bank of America survey last week showed that investors had cut their exposure to UK equities by nine percentage points since Liz Truss took office in September (and then left).
The market appears to be comfortable with Jeremy Hunt as chancellor, as seen by the muted reactions when Ms. Truss resigned and Mr. Hunt continued. Gilt yields have fallen since Hunt reversed ‘mini-budget’ measures over a week ago. Pressure on the Bank of England to raise rates substantially had also subsided. (The BoE then increased rates by 75bp on 3 November, citing ‘global developments’ as well as significant ‘UK-specific factors’.)
While the recent 20th Party Congress closed signalling policy continuity, it disappointed those who were expecting announcements of an exit from the zero-Covid policy and more aggressive policy easing.
The market took no news as bad news and sold off. Valuations of Chinese and Hong Kong traded equities fell sharply in the last week of October. NASDAQ’s Golden Dragon China index lost more than 20% on 24 October after the Congress had ended.
Covid cases in China have risen again despite tightening restrictions. While the total remains below the Shanghai wave of this April/May (see Exhibit 2), the number of provinces with rising cases has climbed to the highest since April, with total or partial lockdowns in areas that account for more than 15% of national GDP. China’s October manufacturing and services purchasing manager surveys (PMIs) reflected the negative impact of these developments. Both indices fell below 50, indicating the economy contracting.
The Party Congress’s heightening of national security as a priority, especially in relation to Taiwan and Hong Kong, signalled a continuation of political tensions with the US.
The recent tightening of US restrictions on exports of tech products to China will likely hurt, but not derail, development of the Chinese tech sector in the medium term. The fact that Chinese stocks did not react to the export restrictions suggests that the market might have discounted much of the negative impact of this US move.
The emphasis of the Congress on national security, technological innovation, high-tech development and social stability reflects the medium-term priorities that determine China’s investment decisions. In terms of investment themes, they are common prosperity (consumption upgrading), hard-tech development (re-industrialisation) and growth of small and mid-cap companies and sectors that are favoured by the authorities under the guided economic restructuring process.
China posted Q3 GDP growth of 3.9% year-on-year (YoY) in the last week of October. For Q4, our research team is estimating 3.6%, implying full-year 2022 growth of 3.2%. Even if Q4 saw growth at a hypothetical 5%, full-year growth would only be 3.5%, well below the Politburo’s growth target of 5.5%.
This argues for continued policy easing in China, in contrast to what other major central banks are doing, to prevent the downside risks to growth from getting out of hand.