Dissatisfaction

The Chinese would have us believe
Their growth targets, they will achieve
Alas, recent data
When looked at pro rata
Shows trust in their words is naïve

Meanwhile, in the UK, inflation
Is rising across that great nation
The market’s reaction
Is dissatisfaction
Thus, Gilts have seen depreciation

Just how fast is China’s GDP growing?  That is the question to be answered after last night’s data dump was distinctly worse than expected.  The big outlier was Retail Sales, which grew only 2.5% Y/Y in August, down from 8.5% in July and far below the expected 7.0% forecast.  But it was not just the Chinese consumer who slowed down their activity, IP rose only 5.3% Y/Y, again well below the July print of 6.4% and far below the forecast of 5.8%.  Even property investment was weaker than forecast, rising 10.9%, down from 12.7% in July and below the 11.3% forecast.  So, what gives?

Well, there seem to be several issues ongoing there, some of which may be temporary, like lockdowns due to the spreading delta variant of Covid, while others are likely to be with us for a longer time, notably the fallout from the bankruptcy of China Evergrande on the property market there.  The Chinese government is walking a very fine line of trying to support the economy without overstimulating those areas that tend toward speculation, notably real estate.  This is, however, extraordinarily difficult to achieve, even for a government that controls almost every lever of power domestically.  The problem is that the Chinese economy remains hugely reliant on exports (i.e. growth elsewhere in the world) in order to prosper.  So, as growth globally seems to be abating, the impact on China is profound and very likely will continue to detract from its GDP results.

Adding to the Chinese government’s difficulties is that the largest property company there, Evergrande, is bankrupt and will need to begin liquidating at least a portion of its property portfolio.  Remember, it has more than $300 billion in USD debt and the government has already said that interest and principal payments due next week will not be made.  A key concern is the prospect of contagion for other property companies in China, as well as for dollar bonds issued by other Chinese and non-US entities.  History has shown that contagion from a significant bankruptcy has the ability to spread far and wide, especially given the globalized nature of financial markets.  While we will certainly hear from Chinese officials that everything is under control, recall that the Fed assured us that the subprime crisis was under control, right before they let Lehman Brothers go under and explode the GFC on the world.  The point is, there is a very real risk that investors become wary of certain asset classes and risk overall which could easily lead to a more severe asset price correction.  This is not a prediction, merely an observation of the fact that the probability of something occurring has clearly risen.

Speaking of things rising, the other key story of the morning is inflation in the UK, which printed at 3.2%, its highest level since March 2012, and continues to trend higher.  This cannot be surprising given that inflation is rising rapidly everywhere in the world, but the difference is the BOE may have a greater ability to respond than some of its central bank counterparts, notably the Fed.  For instance, the UK debt/GDP ratio, while having risen recently to 98.8%, remains well below that of the rest of the G7, notably the Fed as the US number has risen to around 130%.  As such, markets have begun to price in actual base rate hikes by the BOE, looking for the base rate to rise to 0.50% (from 0.10% today) by the end of next year with the first hike expected in May.  While that may not seem like much overall (it is not really), it is far more than anticipated here in the US.  And remember, our CPI is running above 5.0% vs. 3.2% in the UK.

The upshot of the key stories overnight is that taking risk is becoming harder to justify for investors all over the world.  While there has certainly not yet been a defining break from the current ‘buy the dip’ mentality, fingers of instability* seem to be developing throughout financial markets globally.  The implication is that the probability of a severe correction seems to be growing, although the timing and catalyst remain completely opaque.

So, how has the most recent news impacted markets?  Based on this morning’s price action, there is clearly at least some concern growing.  For example, equity markets in Asia were all in the red (Nikkei -0.5%, Hang Seng -1.8%, Shanghai -0.2%) as the fallout of slowing Chinese growth and the China Evergrande story continue to weigh on sentiment there.  In Europe, the continent is under some pressure (DAX -0.1%, CAC -0.5%) although the UK (FTSE 100 +0.1%) seems to be shaking off the higher than expected CPI readings.  As to US futures, as I type, they are currently marginally higher, about 0.2% each, but this follows on yesterday’s afternoon sell-off resulting in lower closes.  Nothing about this performance screams risk-on, although it is not entirely bad news.

The bond market seems a bit more cautious as Treasury yields have fallen further and are down 1.3bps this morning after a 4bp decline yesterday.  This is hardly the sign of speculative fever.  In Europe at this hour, yields are essentially unchanged except in Italy, where BTP yields have risen 1.6bps as concerns grow over the amount of leeway the Italian government has to continue supporting its economy.

Commodity markets show oil prices continuing to rise (WTI +1.35%) after inventory numbers continue to show drawdowns and Gulf of Mexico production remains reduced due to the recent hurricane Nicholas.  While gold prices are little changed on the day, both copper (+0.6%) and aluminum (+1.6%) are firmer on supply questions.  Certainly nothing has changed my view that the price of “stuff” is going to continue higher in step with the ongoing central bank additions of liquidity to markets and economies.

Finally, the dollar is under pressure this morning, which given the risk-off sentiment, is a bit unusual.  But against its G10 brethren, the greenback is lower across the board with NOK (+0.85%) the clear leader on the strength of oil’s rally, although we are seeing haven assets CHF (+0.4%) and JPY (+0.4%) as the next best performers.  The rest of the bloc has seen much lesser gains, but dollar weakness is clear.

The same situation obtains in the EMG markets, where the dollar is weaker against all its counterparts, although the mix of gainers is somewhat unusual.  ZAR (+0.5%) is the top performer on the back of strengthening commodity prices and it is no surprise to see RUB (+0.4%) doing well either.  But both HUF (+0.45%) and CZK (+0.4%) are near the top of the list as both have seen higher than forecast inflation readings recently and both central banks are tipped to raise rates in the next two weeks.  As such, traders are trying to get ahead of the curve there.  The rest of the bloc is also firmer, but the movement has been much less pronounced with no particular stories to note.

On the data front this morning, Empire Manufacturing (exp 17.9), IP (0.5%) and Capacity Utilization (76.4%) are on the docket, none of which are likely to change many opinions.  The Fed remains in their quiet period until the FOMC meeting next week, so we will continue to need to take our FX cues from other markets.  Right now, it appears that 10-year yields are leading the way, so if they continue to slide, look for the dollar to follow suit.

Good luck and stay safe
Adf

*see “Ubiquity” by Mark Buchanan, a book I cannot recommend highly enough

Flames of Concern

While Fed commentary is banned
Inflation has certainly fanned
The flames of concern
And soon we’ll all learn
If prices are acting as planned

Meanwhile transitory’s the word
Jay’s used to describe what’s occurred
But most people feel
Inflation is real
And denial is naught but absurd

It is CPI day in the US today and recently the results have gained nearly as much attention as the monthly payroll data.  This seems reasonable given that pretty much every other story in the press touches on the subject, although as is constantly highlighted, the Fed pays attention to PCE, not CPI.  Nonetheless, CPI is the data that is designed to try to capture the average rate of increases in price for the ordinary consumer.  As well, virtually all contracts linked to inflation are linked to CPI.  So Social Security, union wage contracts and TIPS all use CPI as their benchmark.

Of course, the reason inflation is the hot topic is because it has been so hot over the past nine months.  Consider that since Paul Volcker was Fed Chair and CPI peaked at 14.8%, in 1980, there has been a secular decline for 40 years.  Now, for the first time since 1990, we are likely to have four consecutive Y/Y CPI prints in excess of 5.0%.  Although Powell and the FOMC have been very careful to avoid defining ‘transitory’, every month that CPI (and PCE) prints at levels like this serves to strain their credibility.

This is evidenced by a survey conducted by the New York Fed itself, which yesterday showed that the median expectation for inflation in one year’s time has risen to 5.2% and in three years’ time to 4.0%.  Both of these readings are the highest in the survey’s relatively short history dating back to 2013.  But the point is, people are becoming ever more certain that prices will continue rising.  And remember, while inflation may be a monetary phenomenon, it is also very much a psychological one.  If people believe that prices will rise in the future, they are far more likely to increase their demand for things currently in order to avoid paying those future high prices.  In other words, hoarding will become far more normal and expectations for higher prices will become embedded in the collective psyche.

In fact, it is this exact situation that the Fed is desperately trying to prevent, hence the constant reminders that inflation is transitory and so behavioral changes are unnecessary.  This is what also leads to absurdities like the White House trying to explain that except for the prices of beef, pork and poultry, food prices are in line with what would be expected.  Let’s unpack that for a minute.  Beef, pork and poultry are the three main protein sources consumed in this country, if not around the world, so the fact that those have risen in price makes it hard to avoid the idea that prices are rising.  But the second half of the statement is also disingenuous, “in line with what would be expected” does not indicate prices haven’t risen, only that they haven’t risen as much as beef etc.  I’m sure that when each of you heads to the supermarket to stock up for the week, you have observed the price of almost every item is higher than it was, not only pre-Covid, but also at the beginning of the year.  Alas, at this point, there is no reason to expect inflation to slow down.

Median expectations according to Bloomberg’s survey of economists show that CPI is forecast to have risen 0.4% in August with the Y/Y increase declining to 5.3% from last month’s 5.4% reading.  Ex food and energy, the forecasts are +0.3% and 4.2% respectively.  Now, those annual numbers are 0.1% lower than the July readings, which have many economists claiming that the peak is in, and a slow reversion to the lowflation environment we experienced for the past twenty years is going to return.  Counter to that argument, though, is the idea that the economy is cyclical and that includes inflation.  As such, even if there is an ebb for now, the next cycle will likely return us to these levels once again, if not higher.  PS, if the forecasts are accurate, as I mentioned before, this will still be the fourth consecutive month of 5+% CPI, a fact which makes it much easier for the masses to believe inflation has returned.  You can see why Powell and the entire FOMC continue to harp on the transitory concept, they are desperate to prevent expectations from changing because, as we’ve discussed before, they cannot afford to raise interest rates given the amount of leverage in the system.

Keeping all this in mind, it is easy to understand why the CPI data release has gained so much in importance, even to the Fed, who ostensibly focuses on PCE.  We shall see what the data brings.

In the meantime, the markets overnight have been mostly quiet with a few outlying events.  China Evergrande, the massively indebted Chinese property company has hired two law firms with expertise in bankruptcy.  This is shaking the Chinese markets as given the massive amount of debt involved (>$300 billion of USD debt) there is grave concern a bankruptcy could have significant knock-on repercussions across all sub-prime markets.  It should be no surprise that Chinese equity markets fell last night with Shanghai (-1.4%) and the Hang Seng (-1.2%) both under continued pressure.  However, the Nikkei (+0.7%) rose to its highest level since 1990, although still well below the peak levels from the Japanese bubble of the late ‘80s.  Europe is also mixed with the DAX (+0.1%) managing to eke out some gains while the rest of the continent slides into the red (CAC -0.4%, FTSE 100 -0.3%). US futures are basically unchanged this morning as we all await the CPI data.

Interestingly, despite a lot of equity uncertainty and weakness, bonds are also under pressure with yields rising across the board.  Treasuries (+1.2bps), Bunds (+1.9bps), OATs (+1.6bps) and Gilts (+3.8bps) have all sold off, with only Gilts making some sense as UK employment data was generally better than expected and indicative of a rebound in growth.

In the commodity markets, oil (WTI + 0.6%) continues to rebound as another hurricane hits the Gulf Coast and is shutting in more production.  But metals prices are under pressure led by copper (-1.25%) and aluminum (-1.0%).

As to the dollar, mixed is the best description I can give this morning.  In the G10, AUD (-0.5%) is the laggard after RBA Governor Lowe questioned why market participants thought the RBA would be raising rates anytime soon despite potential tapering in the US and Europe.  Australia is in a very different position and unlikely to raise rates before 2024.  On the plus side, NOK (+0.4%) continues to benefit from oil’s rebound and the rest of the bloc has seen much more modest movement, less than 0.2%, in either direction.

EMG markets are a bit weaker this morning, seemingly responding to the growing risk off sentiment as we see ZAR (-0.65%) and RUB (-0.5%) both under a fair amount of pressure with a long list of currencies declining by lesser amounts.  While declining metals prices may make sense as a driver of the rand, the ruble seems to be ignoring the oil price rally, as traders await the CPI data.  On the plus side, KRW (+0.45%) was the best performer as positions locally were adjusted ahead of the upcoming holiday there.

And that’s really the story as we await the CPI release.  The dollar, while softening slightly from its best levels recently, continues to feel better rather than worse, so I suspect we could see modest further strength if CPI is on target.  However, a miss in the print can have more significant repercussions, with a high print likely to see the dollar benefit  initially.

Good luck and stay safe
Adf