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Weekly investment update – The soft underbelly of hard inflation data

Warnings by the US and Chinese authorities have underscored the dilemma of conflicting inflation and growth data, with energy and tight labour markets pushing up producer and consumer prices amid creeping signs of softening growth. This has put global monetary policy, and markets in risky assets, in a bind.

The Dow Jones Industrial Average fell for the seventh consecutive week last week, while the benchmark US Treasury 10-year yield hovered around 3.0% (almost double the 1.6% of a year ago). Commodity prices came under selling pressure as risk aversion among investors mounted. Safe-haven flows pushed up the US dollar, driving its trade-weighted index to near two-decade highs (see Exhibit 1).

Policy warnings…

China fanned market worries early last week, with Premier Li Keqiang warning that the domestic jobs situation was getting ‘complicated and grave’. The country’s zero-Covid policy is taking a heavy toll on the local economy with negative spillover effects globally. While Shanghai’s lockdown may be wound down soon, other major cities (including Beijing) are facing renewed restrictions.

US Federal Reserve Chair Jerome Powell issued a warning mid-week: The Fed could not guarantee a ‘soft landing’ as it looked to get runaway inflation back to its 2% target amid a tight US labour market. The US Senate nonetheless overwhelmingly confirmed Powell for a second term, signalling monetary policy continuity.

Earlier in the week, former Fed Chair Ben Bernanke warned about the risk of stagflation in an interview with The New York Times.

Aggravated by hard inflation data…

US consumer price inflation was 8.3% YoY in April, down slightly from 8.5% in March. However, core inflation (which excludes food and energy prices), rose on the month from 0.3% to 0.6%, a level still too high for the Fed’s comfort.

Services inflation was particularly strong, rising by 0.7% MoM in April, marking the biggest monthly gain since August 1990. Underscoring continued robust consumer demand, retail sales rose by 0.9% vs the prior month, though this marks the third month in a row that the growth rate has decelerated. 

The prospects for inflation to fall back to the Fed’s 2% target anytime soon may not be good: High wage growth – hourly earnings rose at around 5% YoY – could continue to fuel inflation in the near term. We note that services inflation tends to be much stickier than other index components.

From the Fed’s perspective, these price pressures could in turn drive inflation expectations higher.

The market perceives the latest inflation report as sealing a 50bp rate rise at the June and July meetings of Fed policymakers. It also boosts the chances of the Fed persisting in its aggressive tightening stance at later meetings. A key question is the extent to which – and when – higher interest rates will hit real incomes and crimp demand growth, slowing the economy overall. 

The high services inflation data also suggests labour market tightness would have to ease significantly to bring wage growth back to levels that are acceptable to the Fed. We believe something will have to give. If not, the Fed may have to tap harder on the brakes down the line.

The ECB continues to move closer towards a hawkish policy, with the market now expecting its asset purchasing programme (APP) to end in July, to be followed by a 25bp rate rise soon after. Underpinning the ECB’s policy tightening stance is strong inflation, which rose by 7.4% YoY in April (same as in March), and falling unemployment (the jobless rate hit a record low of 6.8% in March).

The war in Ukraine has added to the upside risks to inflation via food and energy price increases and supply bottlenecks. In addition to higher inflation, the ECB also appears to be concerned about the spillover effects from wage increases. An increasing number of policymakers has spoken out recently in favour of an initial rate rise as soon as July.

And creeping signs of slower growth

Indications of weakening growth momentum have appeared, most noticeably in the UK where GDP growth contracted unexpectedly by 0.1% MoM in March.

In the eurozone, industrial production shrank by 1.8% MoM in March and manufacturing output was down by 1.6%. The main culprit was disruption caused by the war in Ukraine. The weakness was concentrated in Germany, whose supply chains are more integrated with eastern Europe. Its car sector is missing components produced in Ukraine.

Even in the US, recent data showed signs of slowing growth. Jobless claims filings showed an increase in initial claims; the May Senior Loan Officer Opinion survey recorded a drop in demand for mortgages; the University of Michigan consumer sentiment May index hit its lowest level since the start of the pandemic; and the May Empire State Manufacturing survey plunged.

China also released weak data, with industrial output, fixed-asset investment and retail sales all showing year-on-year declines. The property market’s woes deepened, with new home sales and starts falling precipitously.

Investment implications

Mr. Bernanke’s warning of stagflation underscores the dilemma facing policymakers and financial markets: Inflation and growth data are sending conflicting signals. Parts of the US yield curve are inverted, pointing to some risk of an economic recession.

The slowdown concerns are linked to inflation forcing the Fed to tighten policy into restrictive territory and turning weaker growth into a contraction.

The situation is similar in the eurozone: inflation is at its highest ever and could lead the ECB to take stronger measures, exacerbating headwinds from weak Chinese activity and a Russia-induced energy supply shock.

Against the backdrop of the continuing Ukrainian conflict and prolonged supply-chain disruptions, we do not favour sovereign bonds and European equities at this point. We prefer commodities, Japanese and emerging market equities, including Chinese stocks.


Disclaimer

Please note that articles may contain technical language. For this reason, they may not be suitable for readers without professional investment experience. Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients. This document does not constitute investment advice. The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay. Past performance is no guarantee for future returns. Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher-than-average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity or due to greater sensitivity to changes in market conditions (social, political and economic conditions). Some emerging markets offer less security than the majority of international developed markets. For this reason, services for portfolio transactions, liquidation and conservation on behalf of funds invested in emerging markets may carry greater risk.

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