Note: I am travelling in Asia until April 24. Limited equipment and different time zones will limit the frequency and depth of my postings.

Hot Inflation Report Derails Case for Fed June Rate Cut Consumer prices rose 3.5% in March and underlying price pressures remained strong

Stubborn inflation pressures persisted in March, derailing the case for the Federal Reserve to begin reducing interest rates in June and raising questions over whether it can deliver cuts this year without signs of an economic slowdown.

The consumer-price index, a measure of goods and services prices across the economy, rose 3.5% in March from a year earlier, the Labor Department said Wednesday. That was a touch higher than economists had forecast and a pickup from February’s 3.2%. So-called core prices, which exclude volatile food and energy categories, also rose more than expected on a monthly and annual basis. (…)

Futures contracts tied to the federal-funds rate show traders see rates ending the year around 5%, according to FactSet, implying just one or two quarter-point cuts this year. Entering January, traders had expected the Fed to cut interest rates six or seven times. (…)

Wednesday’s report had been hotly anticipated because Fed leaders had been willing to play down stronger-than-anticipated inflation readings in January and February as reflecting potential seasonal quirks. But a third straight month of above-expectations inflation data erodes that story and could lead Fed officials to postpone anticipated rate cuts until July or later.

Fed officials have been optimistic about achieving a so-called soft landing in which inflation slows without a sharp downturn in economic activity. To do that, some officials wanted to cut rates pre-emptively before the economy weakens notably. The latest report sets back that effort by depriving them of a credible justification for cutting rates, and it could prompt them to hold rates at their current level, the highest in 23 years, until they see more cracks in the economy. (…)

The overall core index climbed 0.4% from the previous month despite a decline in the prices of goods such as new and used cars and trucks. A problem area was services outside of housing. That category, which includes everything from car insurance to medical care, has been flagged by Fed officials as particularly important because it can be sticky and closely linked to strength of the labor market.

The cost of shelter also increased 0.4% from February, continuing to defy predictions that it would start rising more slowly given private-sector indexes that have shown a marked slowdown in new rents. (…)

On January 29, my post So, You Think You Can Disinflate? debunked the prevailing widespread conviction that Fed policies were causing the so-called “immaculate disinflation”:

So how could inflation “disappear” when demand was so strong, actually accelerating?

• Non-fuel import prices have been negative YoY since March 2023 after exploding in 2020-22. Since most U.S. consumer goods are imported, this largely explains the goods deflation experienced in 2023. Durable goods prices have declined every month since last June, –4.6% annualized in H2’23. Chinese goods import prices have been deflating all of 2023 and were down 3.0% YoY in December.
• The U.S. dollar jumped 13% between mid-2021 and the end of 2023, further reducing import costs.
• Oil prices are down 37% since their peak in June 2022. On a YoY basis, WTI prices dropped 18.1% in 2023. Natural gas prices are down 78% since their August 2022 peak and 61% YoY in 2023. Significantly lower energy costs (heating, cooling, lighting, transportation, manufacturing) helped protect corporate margins last year, alleviating the need to raise prices to offset other cost increases, such as labor.

In truth, this so-called American “immaculate disinflation” is really the result of the U.S. having imported deflating goods with a strong currency coupled with very significant corporate cost reductions from much lower energy prices.

In truth, the Fed’s policies had little, if anything, to do with this recent disinflation, other than, perhaps, higher interest rates having prevented demand from exploding even more…

The March CPI is the 3rd consecutive “bump” on Powell’s disinflationary road. On a quarterly basis, core CPI picked up to an annualized rate of 4.2% in Q1, from +3.4% in Q4’23. Annoying bump, if not an actual jump!

Core CPI MoM%, 3M annualized and YoY% changes

Source: Macrobond, ING

Perhaps the only “good” data in that CPI report is that CPI-Rent rose 0.37%, down from +0.41% in February, right on the Q1 average of +0.37% or 4.5% annualized. Goldman Sachs said the shelter data were “well behaved”.

Wells Fargo, which became more dubious on slowing rentflation after the February print, now says:

Services inflation, however, remains relatively stubborn. The core services index rose 0.5% in March, pushing the three-month annualized rate up to 6.8%. The sharp slowdown in “spot” rents measured by private sector sources remains painstakingly slow to manifest in the CPI. Primary shelter rose 0.4% again in March, with a slight moderation in rent of primary residences set against an unchanged rate of growth in the much-larger owners’ equivalent rent component. We continue to look for shelter inflation to cool this year, but another firm print in March keeps the caution flag up about the timing and extent to which housing inflation will materially slow.

Ed Yardeni is right saying that “Fed officials are likely to be alarmed by the jump in the CPI services inflation rate less rent of shelter. It rose sharply from 2.8% y/y last September to 5.3% in March. It tracks the less volatile “supercore” PCED inflation rate for services less energy and housing.”

The Atlanta Fed’s sticky-price consumer price index (CPI)—a weighted basket of items that change price relatively slowly—increased 5.0% annualized in March, following a 4.0% increase in February. On a year-over-year basis, the series is up 4.5%.

Here’s how David Rosenberg simply dismisses sticky inflation:

It is the “core sticky” price index, which has nothing to do with the contours of the business cycle and is inherently insensitive to Fed policy. That is the culprit: +0.4% MoM for back-to-back months and picking up in March to a +4.5% YoY pace from +4.4% in February. There’s your inflation story.

Yes David, THAT is the inflation story.

Ed Yardeni, still an inflation hopeful, nonetheless makes “no cuts at all” his “base case scenario. So is a 4.75%-5.00% yield on the 10-year Treasury bond in the next few months. We’ve been expecting the stock market rally to pause and suggested taking some profits, but we still expect the S&P 500 to end the year around 5400.”

The Atlanta Fed’s Wage Growth Tracker was +4.7% in March, down from +5.0% in February. For “job changers”, the Tracker in March was +5.2%, down from +5.3% in February. For “job stickers”, the Tracker was +4.5%, down from +4.7% the prior month.
Composition-adjusted wages are still rising around 5%. (All 3-m m.a.)

Meanwhile, this “new” problem is perking up. A jump in the red line nearer the blue line would be quite a bump.

Source: Chen Zhao, Alpine Macro

Remember that the two major factors impacting services inflation are wages and energy.

Bank of Canada holds rate steady, says it’s more confident in inflation easing

(…) At a press conference after the decision, Mr. Macklem refused to put a timeline on when the bank would start easing monetary policy. But he did say a rate cut at the next meeting in June was “within the realm of possibilities,” as members of the governing council become more confident that inflation is heading back to the 2-per-cent target.

Both headline and core inflation fell more than expected in January and February, and a number of the bank’s indicators of future price pressures are easing.

“We are seeing what we need to see, but we need to see it for longer to be confident that progress toward price stability will be sustained,” Mr. Macklem said. “The further decline we’ve seen in core inflation is very recent. We need to be assured this is not just a temporary dip.” (…)

Mr. Macklem said that the governing council had discussed the possibility of a rate cut this week, but that there was a clear consensus to remain on hold for now. He said the officials remain wary of cutting interest rates too soon or moving too quickly once rate cuts start.

”We don’t want to leave monetary policy this restrictive longer than we need to. But if we lower our policy interest rate too early or cut too fast, we could jeopardize the progress we’ve made bringing inflation down,” Mr. Macklem said.

In its quarterly Monetary Policy Report, the bank downgraded its forecast for inflation and upgraded its forecast for economic growth, with the latter revision largely due to rapid population growth.

Annual consumer price index inflation hit a four-decade high of 8.1 per cent in 2022, and has been declining since then. Central bank economists now see inflation averaging 2.6 per cent this year, down from the previous estimate of 2.8 per cent.

Inflation is projected to remain close to 3 per cent in the second quarter of 2024, partly as a result of rising oil prices. It is then expected to move below 2.5 per cent in the second half of the year, led by slower price growth for shelter and food.

The bank expects inflation to reach its 2-per-cent target in 2025. (…)

Recent GDP growth, however, has come in stronger than the bank expected. The bank revised its first quarter annualized GDP forecast to 2.8 per cent from 0.5 per cent. And it upgraded its 2024 GDP forecast to 1.5 per cent from 0.8 per cent.

Much of this increase is being driven by much stronger-than-expected population growth, which has continued to drive overall economic growth even as GDP-per-capita has declined over the past 18 months.

Economic growth has also received a boost from the exceptionally strong U.S. economy, which has supported Canadian exports, as well as several idiosyncratic factors, such as the end of public sector strikes in Quebec. (…)

The bank noted that government spending is projected to pick up from 2.5 per cent in the second half of 2023 to 3.5 per cent in the first half of 2024, based on recent provincial government budgets. That estimate does not include spending in the upcoming Federal government budget, which will be delivered on April 16.

In the past, Mr. Macklem has warned that increased government spending could get in the way of inflation coming down. (…)

Alongside its updated forecasts, the bank also increased its estimate of the “neutral rate” by a quarter percentage point. The neutral rate is the bank’s estimate of where the policy rate would settle if inflation were on target and the bank was neither trying to stimulate nor restrain the economy.

The new estimate puts the neutral rate between 2.25 per cent and 3.25 per cent. This revision was driven largely by the U.S. policy makers increasing their neutral rate estimate, although there were also domestic factors involved, including changing demographics and savings patterns in Canada.

The neutral rate is a long-term concept, and in the press conference, Mr. Macklem said that the revision is not having an impact on the bank’s near-term monetary policy decisions.

ECB to set up June rate cut after rapid inflation fall

Fitch Cuts China’s Outlook as Fiscal Strain Starts to Bite

China’s public finances are being strained by a shaky economy, a prolonged property slump and a rising fiscal deficit.

That is the verdict of global credit-rating company Fitch, which revised its outlook for China’s A+ credit rating from stable to negative on Wednesday, while also affirming the rating. (…)

The move followed a similar change by Moody’s Investors Service in December. The New York-based firm kept China’s long-term rating of A1 intact but changed the outlook from stable to negative. (…)

China’s local governments are facing a mountain of liabilities, with some analysts putting their hidden debt as high as $11 trillion. They were squeezed by the real-estate slowdown, since for years land sales provided a steady stream of income to local governments and made up for shortfalls elsewhere. Local government-financing vehicles, which allowed regional governments to fund off their own balance sheets, compounded the pain.

The debt problems in the country’s local governments have forced Beijing to take a bigger role in financing economic growth. In March, China said it would issue $139 billion of ultralong special Treasury bonds this year, turning what was once a crisis management tool into a regular source of funding. Beijing has also approved “special refinancing bonds” for local governments and encouraged banks to lend to them.

But that may not be enough. Fitch said China’s gradual approach to managing the debt burden of local government financing vehicles means the risks are likely to remain for some time, draining fiscal resources. It thinks China’s government debt will hit 61.3% by the end of this year, up from 56.1% in 2023.

Fitch also predicts China’s fiscal deficit will rise to 7.1% of gross domestic product in 2024, up from 5.8% last year. The credit rating company said the median fiscal deficit of countries with an A rating is 3%. (…)

Note: I am travelling in Asia until April 24. Limited equipment and different time zones will limit the frequency and depth of my postings.

Visiting China almost at the same time, The Economist editor and KKR’s Head of Global Macro differ markedly on their assessment.

The Economist:

Xi Jinping’s misguided plan to escape economic stagnation It will disappoint China’s people and anger the rest of the world

(…) Mr Xi’s plan is fundamentally misguided. One flaw is that it neglects consumers. Although their spending dwarfs property and the new productive forces, it accounts for just 37% of gdp, much lower than global norms. To restore confidence amid the property slump and thereby boost consumer spending requires stimulus. To induce consumers to save less requires better social security and health care, and reforms that open up public services to all urban migrants.

Mr Xi’s reluctance to embrace this reflects his austere mindset. He detests the idea of bailing out speculative property firms or giving handouts to citizens. Young people should be less pampered and willing to “eat bitterness”, he said last year.

Another flaw is that weak domestic demand means some new production will have to be exported. The world has, regrettably, moved on from the free-trading 2000s—partly because of China’s own mercantilism. America will surely block advanced imports from China, or those made by Chinese firms elsewhere. Europe is in a panic about fleets of Chinese vehicles wiping out its carmakers. Chinese officials say they can redirect exports to the global south. But if emerging countries’ industrial development is undermined by a new “China shock”, they, too, will grow wary. China accounts for 31% of global manufacturing. In a protectionist age, how much higher can that figure go?

The last flaw is Mr Xi’s unrealistic view of entrepreneurs, the dynamos of the past 30 years. Investment in politically favoured industries is soaring, but the underlying mechanism of capitalist risk-taking has been damaged. Many bosses complain of Mr Xi’s unpredictable rule-making and fear purges or even arrest. Relative stock market valuations are at a 25-year low; foreign firms are wary; there are signs of capital flight and tycoons emigrating. Unless entrepreneurs are unshackled, innovation will suffer and resources will be wasted.

China could become like Japan in the 1990s, trapped by deflation and a property crash. Worse, its lopsided growth model could wreck international trade. If so, that could ratchet geopolitical tensions even higher. America and its allies should not cheer that scenario. If China was stagnating and discontented, it could be even more bellicose than if it were thriving.

If these flaws are obvious, why doesn’t China change course? One reason is that Mr Xi is not listening. For much of the past 30 years, China has been open to outside views on economic reform. Its technocrats studied global best practice and welcomed vigorous technical debates. Under Mr Xi’s centralising rule, economic experts have been marginalised and the feedback leaders used to receive has turned into flattery.

The other reason Mr Xi charges on is that national security now takes precedence over prosperity. China must be prepared for the struggle ahead with America, even if there is a price to pay. It is a profound change from the 1990s and its ill-effects will be felt in China and around the world.

KKR (Henry McVey) (my emphasis)

We left Beijing thinking that the economy in China is finally getting a bit better, on a cyclical basis. Easy comparisons certainly matter, but the asynchronous nature of the current global recovery is starting to feel at least a little more synchronized than in prior trips. For example, several logistics companies suggested that demand from the U.S. is picking back up.

However, the real structural story on which to focus, in our view, remains the acceleration in intra-Asia trade. Asia is becoming more Asia centric as trade within the region rises – in 1990, just 46% of Asian trade took place within Asia, but by 2021, that figure had reached 58%. Our estimate is that this ratio increases another 10% in the coming years, which would put China and its peers in the region much more in line with Europe and North America.

In terms of what is working, the growth of a greener economy remains robust. Though it is only 10% of China’s GDP, we estimate this segment is growing around 20% year-over-year. At the manufacturing level in China, there are three areas of focus around decarbonization.

First, there is the intention to reduce the carbon footprint of manufacturing. As one example, the recycling of key inputs such as cobalt is seen as critical.

Second, there is a focus on the transportation of goods, with a greater emphasis on the efficiency of onboarding and logistics (including tangible stories about companies using AI to improve optimizations).

Finally, there is electricity, with renewable energy capacity already reaching 1.45 billion kilowatts in 2023, accounting for more than 50% of the total installed power generation capacity.

There is also a huge focus on ‘upgrading’, especially as it relates to China’s industrial footprint, but also the housing market. On the industrial front, China now boasts over 50% market share in the installed global robot industry and has reported having 10,000 provincial-level digital workshops and 5,600 national-level green factories. Said another way, high quality, lower emissions, and better technology are all a focus.

Utilizing ultra-long-term government bonds, China is launching an equipment replacement and upgrade scheme (RMB 5 trillion or $700 billion plus per year), mostly focusing on energy efficiency, automation, and digital transformation.

Exports are also doing fine. In fact, despite rising tariffs and geopolitical tensions, China is still a global market share winner. The country has both shifted its product mix as well as its customer base. Importantly, though, these numbers do not include output in countries like Vietnam and Mexico, where China is increasingly viewed as a ‘local’ manufacturer.

To be sure, though, we are optimistic less so because we think that GDP growth is going to snap back quickly. Rather, as our trip confirmed, there is a playbook to both build on existing strengths as well as to tweak policies to create more stability, especially as it relates to Real Estate and consumer confidence.

In terms of what is still burdensome to the Chinese economy, three things again bubbled to the surface during our visit.

First is Real Estate, which continues to be an ongoing issue. (…) thus far, much of the correction in China has centered on volume. One developer told us that not only is the problem still big, but it is also complicated as housing liabilities extend across the private and public sectors as well as across local and central government levels. Thus, there is no quick fix.

(…) the housing market correction may be just halfway complete. (…) This ‘slow burn’ speaks to the adverse impact of not moving quickly to write-off assets within the banking system as well as to the importance of a strong monetary response aimed at improving confidence.

China’s housing prices have barely corrected in absolute terms. We think this may be partly related to statistical issues and partly to regulatory restrictions on the setting of housing prices as well as households’ understandable unwillingness to sell at a ‘low’ price. (…) we think it is likely that we see further correction pressures down the road.

By the end of 2023, China had built a huge inventory of housing, perhaps in the neighborhood of nearly 25 million units, including three million completed and 22 million units of forward housing to be delivered. And remember that household formation is only 6-8 million per year. This sizeable mismatch, we believe, means that, unless there is more government intervention to upgrade quality and/or write off assets, it will take considerable time to digest the inventories.

Second, much of the quality upgrade thesis we heard about as it relates to housing, white goods, consumer transportation, etc., is predicated on a rebound in consumption. However, savings rates continue rising, a reflection that there is still a real need for improved confidence before this upgrade cycle can become more self-sustaining, we believe.

As a result of the scarring effect from the pandemic, including a postponement of consumer upgrades and large expenditures, as well as an uptick in the youth unemployment rate, consumer confidence fell sharply over the past three years. This reality led to excess savings soaring to 15% of 2023 retail sales. However, were consumer confidence to recover and savings to return to pre-COVID levels of around 29% from its current level of almost 33%, Changchun estimates that it could add RMB 7 trillion (or nearly one trillion U.S. dollars) to the economy over a three-to-five-year period.

There is, however, good news on two-fronts consumption-wise. We note the following:

• Urbanization is still at 66%, which means, using developed market peers as a guide, that China still has 10-12% more in potential gains. This translates to 150 million or more Chinese consumers who are poised to see their incomes increase as they move towards urban hubs. At the same time, some local scholars estimate that around 170 million migrant workers who have been living in cities haven’t registered in the hukou system, a resident status that grants eligibility to access the urban social welfare system, including things like health care insurance, pension, and public education, among others. They expect that granting hukou to these residents would stimulate additional RMB 1.2 trillion or around $170 billion in consumption.
• Recent government reports show that disposable income per household increased by 6.1% in 2023, which is slightly better than overall economic growth. While conspicuous consumption is down in China, buying basic goods and services as well as modest lifestyle upgrade activity, especially in the middle to higher income range, remains solid. Indeed, this kind of economic momentum is consistent with what we see in our portfolio companies, the lion’s share of which are consumer and services focused. Top line growth is solid, margins are holding, and consumers are spending on less conspicuous items such as ‘smart homes’, pets, and recreational activities. Domestic travel is also strong. (…) We also think that there could be more appetite for higher end consumers to travel outside China in 2025, including to Japan and Europe.

Third, many locals feel that more can be done to modernize the capital markets so that foreign capital feels more comfortable both entering and exiting the country. China’s equity market is cheap by most measures, but it lacks a catalyst to enjoy some of the multiple expansion it probably deserves. At the same time, we believe the potential for domestic market reform should be embraced. Specifically, similar to what we have seen in Japan and India, we think that there needs to be policies put in place to encourage diversification of domestic savings away from property, deposits, and increasingly gold into other asset classes including local Chinese Equities and Credit.

Moreover, if we are right about lower rates at a time of 1) increasing retirement; and 2) heightened geopolitical tensions, now is the time to focus with a sense of urgency on modernizing China’s domestic asset management industry.

Where does China go from here?

We left China thinking that there are several key areas where the country intends to focus so that it can maintain its recent momentum.

#1: Focus on inflation perceptions. First, policy makers will likely need to work hard to ensure that consumers do not begin to ponder the potential for sustained disinflation. (…) inflation is likely too low relative to the government’s target of up to three percent. At the moment, there is confidence within the country that inflation will bottom during the second half of the year and begin to rise, but we still think that more could be done in this area to boost expectations. Potential fixes mentioned to us include supply side reforms to monitor excess production across industries as well as moving more swiftly on remedying the housing situation. (…)

#2: Focus on productivity. China executives acknowledge that the country may need to shift from a dependence on high levels of leverage to productivity enhancements aimed at fueling growth, especially as its demographics turn less favorable and the rate of urbanization slows. (…) the economy today is relying much more heavily on leverage for growth than in the past, which ultimately lowers China’s productivity growth.

As part of this transition towards a higher level of a more levered state, China’s private ownership (of the top 100 listed companies) has also started to decline commensurately since 2020. A potential consideration to reverse this decline would be to shift capital and focus back towards the private sector to help reignite productivity growth. Consistent with this view, there is a growing local contingent that is in favor of more supply side reforms that accelerate permitting, improve processes, and reward employment growth.

#3: Focus on the perception of the public markets. While China has enjoyed material growth in recent decades, this growth has not translated into strong gains in its equity market. Importantly, as geopolitical tensions intensify around the world, the Chinese government has indicated that a strong and robust domestic capital market will be increasingly important. This effort will not be easy under its current construct, given recent uncertainty surrounding policy as well as a heavy weighting in its indexes towards financials and state-owned enterprises.

That said, we did hear two potential paths forward in this area to improve the quality of the capital markets/retirement savings in China. First, there is the potential for the country to push harder to allow more companies outside of the digitalization and green sectors to go public. China has numerous world class consumer companies, but many of them are stuck in the hands of private investors who can’t yet access the public markets.

Second, we heard about a greater desire to create a more sophisticated retirement savings market, including a focus on longer-term investing strategies as well as creating more transparent and higher quality savings vehicles for individuals.

Conclusion

Over the past year, I have spent an increasing amount of my travel time in China, Japan, and India. Without question, this region is undergoing a fundamental repositioning, including both more interconnected trade as well as increased geopolitical rivalry.

(…) Within China, the story is changing materially, with Green initiatives and Industrial Automation now driving incremental growth in the local economy. (…) Against a more sluggish structural growth backdrop as well as heightened geopolitical concerns. China will likely look to create a strong domestic market that entices both domestic and foreign capital to support its growth in a more consistent manner.

Not surprisingly, as geopolitical tensions continue to rise against more challenging demographics, we are seeing this type of framework also being embraced in India, Japan, and even the United States.

Overall, we left Beijing somewhat encouraged. To be sure, though, we are optimistic less so because we think that GDP growth is going to snap back quickly. Rather, as our trip confirmed, there is a playbook to both build on existing strengths as well as tweak policies to create more stability, especially as it relates to Real Estate and consumer confidence. If done properly, these policy shifts could reward investors across the region who have positions in Equities, Credit, and many parts of Real Assets

The Economist talks the old playbook (more stimulus to boost consumer demand), in a U.S. centered world, and faults Mr. Xi’s “centralising rule” as well as his character flaws (“unrealistic”, “unpredictable”, “self-centered”).

It makes no sense to throw money to shocked, wary and worried consumers. They will save it until confidence returns, always a slow process, particularly when real estate values are concerned.

With all his flaws, Mr. Xi is a very smart man. Based on his more recent actions, he seems to have learned much in recent years, including the necessity for China to reduce its dependance on the U.S.. An engineer, he is very analytic and systematic and he gets technology. KKR’s analysis reflects the reengineering of China’s growth within a completely new global environment. Like it or not, China has a plan. Like it or not, the plan will be implemented by this centralized regime.

Currently in Singapore and having read its history, I can appreciate the results of a smart, thoughtful, centralized social and economic plan. To be sure, China is no Singapore, but time will tell if Xi Jinping ends up close to being another Lee Kwan Yew in framing the right vision for China amid numerous significant challenges.

In my book, China was long an un-investable growth market, mainly for political/ethical reasons, but also because other investable markets were offering enough opportunities to profitably invest capital without the “China risk”.

Given how relative valuations have evolved and how Western politics have devolved, I find myself rethinking my thinking.

BTW, to KKR’s point about the acceleration in intra-Asia trade, this CrossBorderCapital chart shows how Asia-Pacific trade has recovered well above total world shipping volumes and above its levels of the past 20 years.