‘Stagflation’ – stubbornly high inflation and weakening economic growth – is the cause of a monetary policy dilemma for the West’s central banks: Should they tighten further to bring down inflation, when weak growth suggests they should perhaps be cutting rates? Meanwhile, lower inflation and a more benign growth outlook for Asia’s emerging markets, boosted by China’s reopening, mean central banks in the East face less daunting challenges. This sharp divide could drive portfolio flows into Asian and Chinese asset markets in the coming months.
Sticky US inflation
The closely-watched US consumer price index (CPI) inflation rate for January, released on 13 February, came in at 6.4% year-on-year (YoY), slightly below December’s 6.5%. On a monthly basis, the headline rate actually ticked higher, from 0.1% to 0.5%. While oil prices are keeping headline CPI elevated, core inflation rose by a strong 5.6% YoY in January after 5.7% in December.
The report showed slowly receding inflationary pressures, but the current rate remains well above the US Federal Reserve’s (Fed) 2% target. The Fed is uncomfortable with the strength of the US labour market and the risks of a wage-price spiral. In January, wage growth was 4.4% YoY and the unemployment rate fell to a 53-year low of 3.4%.
All of which goes some way to explaining Fed Chair Powell’s recent assessment that “the disinflation process has started” but more interest rate increases might be needed if the jobs market remains this strong. In his public comments during the second week of February, he said he does not foresee inflation falling to 2% before 2024.
The West-East inflation differential
The West-East market divide is reflected by inflation rate differentials (see Exhibit 1). Inflation in the G3 economies (Europe, the UK and the US) averaged 9% YoY in December 2022; in Asia (excluding China) it averaged only 5% YoY.
China’s inflation is among the lowest in the world. Its December 2022 headline CPI inflation rose by only 2.1% YoY with core inflation at 1.0% YoY. China’s producer price index (PPI) has been in deflation since September 2022, and fell by 0.8% YoY last month. There is no risk of tighter monetary policy in China.
China’s low inflation rate in combination with a renminbi that is not appreciating mean China is not exporting inflation to the rest of the world. Asia’s supply-chain relationship with China means the region is receiving the spillover from China’s disinflationary impact.
The going is still tough in the West…
Macroeconomic indicators have been flashing recession risk in the West. Notably, the US yield curve remains inverted. The recent Senior Loan Officer Survey signalled economic weakness ahead, with banks tightening their lending criteria on the back of softer loan demand.
In Europe, the flash estimate for fourth quarter 2022 GDP growth in the eurozone was just positive (0.1% QoQ). The data breakdown, however, showed a sharp fall in household spending. Other data indicates weak consumer confidence and mixed investment sentiment.
Japan’s Q4 2022 GDP grew by a weaker-than-expected 0.6% quarter-on-quarter – almost 1% below the Q4 growth rate in 2019, before the pandemic.
…but more optimism in the East
Meanwhile, the reopening of China’s economy has boosted optimism for Asia’s growth and commodity demand. While it will still take some time for improvements in the major macroeconomic indicators to reflect the impact of the recent policy easing, data from the Lunar New Year holiday already shows that domestic mobility and services sector demand are rebounding strongly. Bank credit, typically a leading indicator of economic activity, grew by a higher-than-expected 11.1% YoY in January (see Exhibit 2).
The expansionary impact of China’s reopening will doubtless spill over to Asia, helping to offset some of the growth slowdown in developed markets. Sino-Asia trade is now bigger than Sino-US trade, so open economies that have more exposure to China than to the West should see a greater net benefit from China’s recovery.
Net commodity exporters, especially of oil, will also likely benefit from terms-of-trade support, since improving Chinese demand tends to tighten global commodity markets at the margin. Finally, tourism-reliant economies, especially those that rely on visitors from China, have upside potential.
China’s reopening has led our investment teams to increase their allocation to emerging market equities, with valuations looking attractive and earnings upgrades likely in the coming months.
For full details of our asset allocation, click here.