KKR on the January CPI
The January CPI report strengthens our view that growth and inflation will be more resilient this year, even more than we previously thought. Against that backdrop, we expect fewer Fed cuts.
We continue to argue that we are in a Regime Change where there is a ‘higher resting heart rate’ for inflation this cycle. This report confirms our view that investors have been overly optimistic about the Fed cutting rates into an environment that is defined by low growth, low inflation, loose monetary policy, and tight fiscal policy.
That environment is one that we have permanently exited, we believe. Key to our thinking is that four drivers – more fiscal stimulus, a messy energy transition, heightened geopolitics, and tight labor markets – will make this cycle different. (…)
Despite some seasonal noise, the details suggest that Core Services inflation (the key focus area for Fed policymakers right now) remains even more resilient than we had expected.
Supercore inflation (Services inflation ex-Shelter and Healthcare) accelerated for the third month in a row and is now running at around six to seven percent annualized on a three-month moving average basis. While we think that there is some residual seasonality at play here (e.g., we saw a similar ‘blip’ around 3Q/4Q last year), it is clearly taking longer than policymakers had hoped for inflation to cool in labor-sensitive sectors.
Meanwhile, Shelter inflation unexpectedly accelerated to +0.5% from +0.4% in December, driven by a sharp increase in Owners’ Equivalent Rent. Although market rents have been on a cooler path, Chair Powell’s latest press conference suggests that he wants to see that slowdown reflected in official BLS data; all else equal, the January data will encourage Fed policymakers to take a more patient approach to rate cuts.
Netting together this month’s data (including payrolls, ISMs, and claims), we are raising our 2024 real GDP forecast even further above consensus to +2.5%, up from +2.0% previously (consensus is +1.7%). These increases support our view that we are living in a higher nominal GDP environment this cycle.
We think seasonals will push Services CPI lower by this summer (Exhibit 1), allowing the Fed to start cutting in June (vs. our prior May baseline). Our base case now moves back to three cuts this year (versus four previously), which raises our YE 2024 fed funds forecast to 4.625%. Our YE 2025 forecast rises to 3.875%, from 3.625% previously. (…)
We raise our YE 2024 10Y UST target to 4.25% from 4.0% previously, while retaining our longer-term view that bond yields settle around 4.0% (meaning 4.25- 4.5% represents reasonable value for longer term allocators).
AMERICAN EXCEPTIONALISM
Japan Economy Shrinks Unexpectedly Japan dropped a rank to became the world’s fourth-largest economy as growth in tourism spending failed to offset sluggishness in domestic consumption and capital spending.
Japan’s gross domestic product shrank 0.1% in the three months to December from the previous quarter, government data showed, weaker than economists’ forecast for 0.2% growth. The economy contracted 0.8% in the July-September quarter.
Although the economy weakened late in the year, real GDP grew 1.9% in 2023, improving on 2022’s 1.0% expansion. In nominal terms, Japan’s GDP was worth 591.482 trillion yen, or about $3.93 trillion, at current exchange rates. That puts Germany’s economy, with its 2023 GDP of about $4.42 trillion, in third spot globally. (…)
Technically, the Japanese economy is in recession, as it has contracted for two consecutive quarters. However, the data are preliminary and the drop small enough to leave room for doubt about whether the country has really slipped into recession. Revised estimates due next month could paint a different picture.
Based on the PMI surveys, Japan manufacturing is still contracting but services are a strong offset. The composite PMI rose from 50.0 to 51.5 in January
led by the fastest expansion in services business activity
in four months, while the reduction in manufacturing output eased
to a three-month low.There was a renewed, albeit fractional rise in new order inflows at Japanese private sector firms that was the first since last September and was led by the steepest rise at service providers for four months.
Eurozone Industrial Production Unexpectedly Expands Amid Signs Recovery for Sector
Total production rose on 2.6% on month in December, according to figures published Wednesday by European Union statistics agency Eurostat, the second-straight rise, after a revised 0.4% increase recorded in November.
December’s result upended expectations of a fall of 0.2%, according to a consensus of economists polled by The Wall Street Journal.
Amid low demand and steep interest rates, industrial production had fallen in four of the five months prior to November. But purchasing managers’ survey data has shown that manufacturing sentiment has improved in each of November, December and January, indicating that there could have been some bottoming out of weakness in the sector.
Compared with December 2022, output grew 1.2%—the first time it has risen on year since February 2023.
The rise in production was driven by a 20.5% increase on month in capital goods, which incorporate assets like machinery, equipment and vehicles that are used to make consumer goods. Meanwhile, energy output climbed 0.3% on month, production of durable consumer goods rose 0.5%, while for nondurable goods it ticked up by 0.2%. (…)
But in Germany, traditionally the workhorse of European industry, the environment is still weak, with production falling there by 1.2%. In Spain, it dipped by 0.4%, while output grew in both France and Italy by 1.1%. (…)
Apparently not out of the wood yet:
New business inflows fell in January, extending the current sequence of shrinking demand that began last June. Weaker falls in new orders were seen at manufacturers and services companies, leading to the softest overall rate of decline in sales for seven months. Although new business from external clients fell for a twenty-third month in a row, January’s decrease was the least pronounced since April 2023.
Euro-Area Economy Is Losing Momentum, EU Says, Slashing Outlook
Gross domestic product in the currency bloc will accelerate only slightly to 0.8% this year after 0.5% in 2023, the European Commission said in a report Thursday. In November, it had predicted a more marked improvement to 1.2%. It also cut its 2025 forecast to 1.5%, from 1.6%
“The rebound expected in 2024 is set to be more modest than projected three months ago, but to gradually pick up pace on the back of slower price rises, growing real wages and a remarkably strong labor market,” Economy Commissioner Paolo Gentiloni said in a statement. (…)
In recent weeks, both the International Monetary Fund and the Organization for Economic Cooperation and Development cut their GDP forecasts for European countries in 2024, while revising up global expectations. (…)
So far, the deterioration in the euro-area outlook has not caused the European Central Bank to reconsider its record-high 4% interest rate, though policymakers acknowledge that borrowing costs will be reduced this year. (…)
ECB President Christine Lagarde — speaking the EU lawmakers on Thursday — cautioned again rushing into rate cuts as rising salaries becoming an ever-more significant driver of inflation. (…)
“Incoming data continue to signal subdued activity in the near term,” Lagarde said. “However, some forward-looking survey indicators point to a pick-up in the year ahead.”
Which ones Mrs. Lagarde?
- The HCOB Germany Composite PMI Output Index slipped deeper into sub-50 contraction territory in January, dropping from December’s 47.4 to a three-month low of 47.0.
- German Economy May Have Shrunk in First Quarter, Nagel Says
- France‘s manufacturing sector remained under intense pressure at the beginning of the year as indices for output, new orders and employment remained in deep contraction territory. The latest survey data showed another considerable month-on-month drop in new orders. France’s service sector saw its downturn extend into the new year, as client hesitancy and generally subdued demand conditions reportedly weighed on activity and new business inflows.
- France to Lower Its Growth Forecast as EU Outlook Worsens
- Driven by a renewed expansion in the service sector, the HCOB Italy Composite PMI Output Index re-entered growth territory for the first time since last May, rising from 48.6 in December to 50.7 in January. That said, the rate of increase was only marginal. New business across the Italian private sector also rose at a slight pace in January. The upturn was led by service sector firms as manufacturers continued to record a drop in new sales, albeit softening on the month.
- The seasonally adjusted S&P Global UK Manufacturing
Purchasing Managers’ Index™ (PMI®) posted 47.0 in January,
up from 46.2 in December but below the earlier flash estimate
of 47.3. The PMI has signalled a deterioration in operating
conditions in each of the past 18 months. Four out of the five
PMI sub-components – output, new orders, employment and
stocks of purchases – were showing trends consistent with
overall contraction. - UK Recession Deals Fresh Blow to Sunak’s Economic Promises
The UK and China together absorb nearly 25% of EU exports.
European banks and their $1.5 trillion commercial property headache
European banks have about 1.4 trillion euros ($1.50 trillion) in loans to the troubled commercial property industry, amid a steep fall in office prices on both sides of the Atlantic and investor concerns about lenders’ ability to handle the risk.
Banks in Germany have become a particular focus because the country is in its worst real-estate slump in decades – one marked by insolvencies, halted construction and a freeze in property deals. Investors dumped the shares of one of Germany’s top property financiers last week, concerned about its exposure to the U.S. market.
Fallout from the downturn also has the potential to affect banks in France and the Netherlands, which are among Europe’s biggest commercial real estate lenders. (…)
The real-estate sector accounted for roughly a fifth of Germany’s output, with low interest rates pulling billions of euros into property.
Industry experts say prices have further to fall. There is currently not much price transparency, with owners unwilling to sell at reduced prices and asset managers slow to revalue their holdings.
“Valuations are still too high. Everybody knows it. But at a certain point of time, people need to drop their pants,” said Alexandre Grellier, founder of Drooms, a service provider to property dealmakers. (…)
With 285 billion euros in commercial property loans, German lenders account for around a fifth of the EU banks’ 1.4 trillion euros in loans to the sector, based on European Banking Authority data. (…)
Deutsche earlier this month disclosed 17 billion euros in loans to the hard-hit U.S. commercial property market, more than 3% of its entire book. That would make up about a fifth of the 76 billion euros that EU banks overall have lent in the United States, based on EBA data.
Deutsche Pfandbriefbank (PBB), created after the global financial crisis more than a decade ago, is one of Germany’s top property financiers.
It has 5 billion euros – or 15% of its loans – tied up in the U.S. commercial market, PBB has said.
Last week, it doubled its risk provisions, and investors got spooked, dumping its shares and bonds as short sellers moved in. PBB reacted by issuing two separate announcements that sought to reassure the public about its health.
Late on Wednesday, the credit rating agency S&P downgraded PBB due to its links to commercial real estate and gave it a negative outlook. (…)
Some European banks are even bigger in commercial real estate lending than German banks, with France and the Netherlands dominating, based on EBA data. Rabobank and BNP Paribas top the chart.
Loans from French banks to the sector are slightly ahead of Germany’s, according to the EBA data, Netherlands comes in third, ahead of Italy and Spain. (…)
The ECB warned in November that the property slump could last years, although it said the sector was not big enough to create a systemic risk for lenders.
Last month, the head of Germany’s financial regulator stepped-up his warnings, predicting 2024 will be less rosy for bank profits and that real estate was an increasing risk.
Europe Earnings Haven’t Missed This Bad Since 2020
With about a third of companies in the MSCI Europe Index having reported to date, energy, industrials and consumer companies have disproportionately fallen short of expectations.
Industrials had a difficult year, with the percentage of misses steadily rising throughout 2023 as client spending dried up.
About 53% of the companies in the MSCI Europe Index that have reported so far missed estimates, while just over a third posted earnings beats. (…)
SENTIMENT WATCH
Ed Yardeni today wonders if we are in a meltup equity market. Among his evidence charts:
- High, near extreme bullishness:
- NDR has a similar reading from this chart:
- Extended equities:
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The 13,34-week EMA is also extended, but still positive:
This trend helps explain the unending rise of the Magnificent Seven.
As John Mauldin explains, “The recent rise of the “Magnificent Seven” tech stocks is mathematically dooming many others to below-average gains. (…) in 2023, less than 30% of the S&P 500 stocks were able to beat or even match the S&P 500 return.”
Harvard Slashes Healthcare Investments, Tech Rises to 98% of Portfolio
The Harvard Management Company increased its direct holdings of Alphabet and Meta and continued its major sell off of biopharma holdings — which now make up less than 1 percent of the portfolio — during the last three months of 2023.
Meta and Alphabet together make up 70 percent of the HMC’s public portfolio. Light & Wonder Inc., a company that provides gambling services, makes up the third largest stake in HMC’s portfolio. (…)
During the latest quarter, HMC sold its stake in eight of its nine biopharma companies, which are counted as part of the healthcare sector.
The persistent sell-off of stocks within the sector continues a trend that began in early 2021.
In 2020, at the height of the Covid-19 pandemic, healthcare stocks represented 67 percent of HMC’s portfolio. The holdings have now been reduced to less than 1 percent. (…)
Adding to the near total sell-off of biopharma holdings, HMC sold its full position in Grab — a Singaporean tech app — after purchasing over 13 million shares since December 2021.
HMC sold their holdings after shares declined by over 50 percent in value, the first shares were purchased at $7.13 and all were sold at $3.46 apiece last quarter. Grab was once hailed as a long-term growth investment after emerging markets experienced lowered evaluations in 2020, but failed to meet investor expectations.
HMC preserved its direct holdings in semiconductor companies, the most notable including NVIDIA, Taiwan Semiconductor Manufacturing Company, and Advanced Micro Devices. They combine for roughly 8 percent of the portfolio. (…)
Hmmm…
Let me repeat this line:
Meta and Alphabet together make up 70 percent of the HMC’s public portfolio. Light & Wonder Inc., a company that provides gambling services, makes up the third largest stake in HMC’s portfolio.
Interesting trio…