The Temptation to Call the End of Inflation

“…The above chart by Michael Howell of Crossborder Capital shows estimates of global new liquidity. The lines indicate the three-month annualized % growth in the monetary base. Globally [red line], growth in liquidity has ticked up very slightly after dropping to its lowest level since the global financial crisis. In the major G10 economies [grey and yellow], there is a pickup from outright negative growth that has been helped by the startling fall in the US dollar in recent weeks. As many countries use dollar financing, this has the effect of easing conditions everywhere. Last week’s balance sheet data from major central banks show policy liquidity shrinking at 5.3% in local currency terms [yellow] but rising by 2.7% in US dollar terms [grey.] Thus, it is possible that a pivot away from tighter money is already under way…”

John Authers, “The Temptation to Call the End of Inflation,” Bloomberg, December 11, 2022, https://www.bloomberg.com/opinion/articles/2022-12-12/john-authers-calling-the-end-of-inflation-and-buying-china?sref=U3dOGIDF

The Temptation to Call the End of Inflation

Lead Us Not Into Inflation

What have we got to be afraid of? The 2022 drama of the word’s fight against the return of inflation is about to reach its final act. After the US consumer price index on Tuesday, the Federal Reserve holds its last monetary policy meeting for the year on Wednesday, to be followed the next day by the European Central Bank, Bank of England, Swiss National Bank, and Norway’s Norges Bank. Then finally, with any luck, we can all enjoy the World Cup final and send the world into mothballs for the Christmas and New Year holidays.

So where do we stand? Inflation this year far exceeded any estimate, as did the monetary policy response (at the turn of the year, fed funds futures predicted the fed funds rate would hit 0.82% after this week’s meeting; now that market is braced for 4.35%). But after the ghastly surprise of 2022, markets again are coalescing around a view that price rises will imminently come under control. That is clear if we look at implied inflation rates from the swaps market (available on the terminal), which suggest that CPI will be back below 3% by next summer:

Why might they think this? We can answer that first by reference to the broader global picture, and then by looking more closely at the nitty-gritty of central banks’ provision of liquidity to the markets. For the case that it’s reasonable to expect inflation to fall next year, consider this schematic illustration from Academy Securities’ Peter Tchir:

Don’t spend any time on the precise numbers, or the way the different factors have been weighted; this is meant as an aid to thought and conjecture rather than anything precise. Inflation had many driving factors behind it. Among the most important were: The Fed’s expansive monetary policy in 2020 and 2021 (“The Fed” above); the fiscal stimulus administered to tide companies and individuals through the pandemic (“Stimulus”); stresses on global supply chains as businesses began to reopen; the war in Ukraine; and the bubbly behavior that was fostered by the brief but dramatic boom in “disruptive” stocks and cryptocurrencies. The diagram shows Tchir’s rough estimate of how important all these factors have been since the pandemic began. At this point, his model suggests that the Ukraine conflict is the only remaining factor still pushing inflation upwards. By the middle of next year, again on a very simple model, all of the previously inflationary forces will have become deflationary. Intuitively, this model does seem reasonable. It also implies, for Tchir, that the Fed has already gone too far.

If that’s concerning, we also need to look at how far the battle to tame in inflation has come. Central banks across the world have reined in liquidity this year, and the announced policy of “quantitative tightening” implies that they have much further to go, selling bonds into the market to reduce the money in circulation. However, it looks as though this may already have come to a “pivot” point. The following chart by Michael Howell of Crossborder Capital in London shows estimates of global new liquidity:

To be precise, the lines indicate the three-month annualized percentage growth in the monetary base. Globally, growth in liquidity has ticked up very slightly after dropping to its lowest level since the global financial crisis. In the major G10 economies, there is a pickup from outright negative growth that has been helped by the startling fall in the US dollar in recent weeks. As many countries use dollar financing, this has the effect of easing conditions everywhere. Last week’s balance sheet data from major central banks show policy liquidity shrinking at 5.3% in local currency terms but rising by 2.7% in US dollar terms. Thus, it is possible that a pivot away from tighter money is already under way.

The weakening of the dollar can be viewed as a response to implicit easing by the Fed, or it might also have been driven by an increasing belief that inflation really has been licked, and that tightening will soon go into reverse. By trying to anticipate this, the foreign exchange market almost delivers some degree of easier money as a self-fulfilling prophecy. Even if the Fed has already tightened too far, then, it’s possible that markets are already working to blunt the impact on the economy next year. To quote Howell of Crossborder Capital: ‘The US Federal Reserve looks to be leading the cycle once again. Having been the first to tighten starting from around this time last year, recent data suggest that the Fed’s QT cycle is close, or even already at, its nadir. Interest rates are likely to go on rising into 2023, albeit at a slower pace as upward pressure on prices abates, but quantitative policy looks to be changing direction already. The US dollar is responding. From its recent peak levels, it has lost some 14% versus sterling, around 10% against the euro and yen, and 5% versus the renminbi. While other Central Banks may lag the Fed once again, the depreciation of the US dollar will help. Its strength during 2022 has forced EM Central Banks to tighten to underpin their own currencies and has exacerbated already strong inflationary pressures in Western economies. The positive effect is already evident in aggregate policy liquidity growth expressed in US dollar terms. This is now gently expanding having been in negative territory for the last 12 months.”

A broader question concerns the pressures that sustain longer-term inflation. Many of the big global trends driving prices higher have turned, but consumers and businesses across the world have begun to growing accustomed to rising prices. What risk does this create of a self-perpetuating cycle of rising wage demands and rising prices? That’s an imponderable question, but the continuing strength of the US labor market suggests that inflation isn’t beaten yet. Last week, brought publication of the Atlanta Federal Reserve’s Wage Tracker figures for November, which are based on census data and allow a granular look at pay increases across the US.

Average hourly earnings data from the Bureau of Labor Statistics at the beginning of this month also suggest that it’s premature to call a top on rising wages:

We’re about to receive a bombardment of new information about inflation. It will all be useful, but there are longer-term trends whose destination is unclear. Even if and when the central banks reach the point of not raising rates anymore, there will be plenty more uncertainties.

Buy China?

If there’s one almost universally popular call for 2023, it’s “buy China” — not just its bonds, but even its beleaguered stocks. On any simple what-goes-down-must-come-up model, this makes ample sense. China’s stock market endured almost a perfect storm in 2022: Growing trade conflict with the US, and international outrage of corporate governance, contributed to a selloff that widespread shutdowns caused by the Covid-Zero policy would likely have caused in any case. Once Chinese stocks are in a slough of despond, all good contrarians know that it is time to buy.

However, a lot of the bounce has happened in the last two months. Chinese American Depositary Receipts, as measured by the Bank of New York’s index, and Hong Kong-quoted shares covered by the MSCI China Index have more or less caught up with the MSCI All-World index. An epochal 46% fall for the ADRs at one point is now a more manageable 18% drop for the year. Meanwhile, mainland shares represented by the CSI 300 Index have also regained much ground:

Was that the buying opportunity? What case is there for renewed excitement about China? And can we be sure of the ground we stand on? This time last year, JPMorgan Chase & Co.’s much-quoted equity strategist Marko Kolanovic said: “China was a headwind for performance of various assets this year, but we believe China growth will accelerate in 2022, which should further provide support for global equities and cyclical assets.” JPMorgan’s precise prediction was a for a 38% rise in the MSCI China. As the chart shows, that didn’t happen. It’s as well to remember this when looking at Kolanovic’s outlook for China for 2023: “We remain positive on China, due to favorable monetary conditions as well as an eventual full reopening and end of Covid.” There’s certainly a much more attractively priced entry point now than there was a year ago”

Meanwhile, Christopher Wood, a veteran analyst of Asian markets who writes as GREED & Fear for Jefferies, suggests that it’s now safe to enter the water. But it’s important than he is more confident about relative performance (because he sees US earnings and the dollar as challenged), than about absolute performance in an environment that is likely to see a big public health crisis in the next few months: “The growing evidence of further closet Covid easing this week is clearly bullish for Chinese equities and increases the chance that the emerging market asset class has made a major bottom against both the S&P500 and the MSCI World Index. This is particularly the case given the positive earnings upgrade potential for several Asian markets next year and the risk of earnings downgrades in the US in 2023. Global asset allocators should increase their allocation to emerging markets if they agree with GREED & fear’s base case, namely that monetary tightening expectations and the US dollar have peaked.”

There’s a big currency element to this. China’s yuan has enjoyed a dramatic resurgence in the last two months, driven both by lower yields in the US and hopes that post-Covid opening is real and imminent. It’s dropped below 7.0 per dollar — a level that has caused major political tensions in the past — after one of its strongest appreciations in decades:

In its own right, a rebound after a major selloff makes sense for the yuan. But all the China bulls might take note that this big shift has already happened, and might easily reverse if the post-Covid resumption does not go as hoped. It’s worth heeding these words from Marc Chandler of Bannockburn Global Forex: “The US 10-year yield premium over China topped in late October at slightly more than 150 bp. It fell to almost 50 bp last week before settling around 65 bp. Investors have been eager to believe the Covid pivot, but the risk is that they have gotten ahead of themselves. Of course, less testing will generate less detected cases but there will be other signs of rising infections and strains on the healthcare system. That said, even if one wants to accept these developments at face value, the move is too far too fast. The yuan’s surge offers an opportunity to those who are looking for an opportunity to hedge or reduce CNY exposure.”

China is plainly a more interesting investment opportunity than it was 12 months ago. But, just as then, the case might not be quite as clear as it seems.