by Patrick Fearon-Hernandez, CFA, and Thomas Wash
[Posted: 9:30 AM EST] | PDF
Good morning! Today’s Comment begins with our thoughts on the latest Consumer Price Index report and its implications for Fed policy. Next, we discuss the impact that China’s reopening is having on markets. The report concludes with our thoughts on Germany’s response to the U.S. climate-change subsidy initiative.
Inflation Nation: The CPI report will bolster expectations that the Fed will moderate monetary policy this year.
- The December inflation report has bolstered expectations that the Fed will reduce the size of its rate hike at its next meeting. Last month, headline CPI rose 6.5% from the prior year. The increase was in line with expectations and below the previous month’s report of 7.1%. The cooling of inflation will give the Fed some flexibility if it decides to slow the pace of interest rate hikes. On Wednesday, Boston Fed President Susan Collins, a voting member, mentioned that she favored a 25 bps hike in February. Meanwhile, Fed Chair Jerome Powell’s lack of clarity on rate policy reinforced investor sentiment that he may favor a downshift in rate rises.
- Although the Fed is considering moderation in its policy, other central banks are hesitant to follow suit. European central bank official Olli Rehn insisted that the ECB needs to raise rates significantly in its next meeting to contain inflation. His French counterpart Francois Villeroy also mentioned the importance of raising rates into restrictive territory. In Japan, a review of the central bank’s ultra-easy monetary policy has led to speculation that the Bank of Japan could make another adjustment to its yield-curve-control ban. The reluctance to moderate policy in Europe is related to inflation being well above U.S. levels; meanwhile, rising inflation in Japan may force the bank to tighten.
- The combination of BOJ tightening speculation and Fed moderation has led to a strong uptick in the JPY.
- A moderation in the Fed’s monetary tightening will allow other central banks in the developed world to close the interest gap with the U.S. The rise in rates in Europe and possibly Japan will put downward pressure on the greenback. If true, international equities could provide attractive opportunities. Additionally, a consistent deceleration in inflation suggests that the Fed may be able to pull off the elusive soft landing.
China’s Back: There is much anticipation regarding the reopening of the Chinese economy, but the lack of COVID data may be a problem for markets.
- Commodity prices are surging due to expectations that the end of China’s Zero-COVID restrictions will boost global demand for materials. On Wednesday, copper prices soared to $9000 a ton, its highest level since June 2022. The rampant rise in the metal is due to hopes that the increase in economic activity in China will boost global growth. Oil prices had a similar bounce as the price of crude jumped 3% on Wednesday, despite a strong build-up in U.S. inventories. It is now expected that Brent could hit $110 a barrel by the third quarter when China and other Asian economies fully reopen.
- The optimism has boosted Chinese equities. Year-over-year performance of the MSCI China Price Index has now surpassed the S&P 500.
- Despite the improvement in market sentiment, the lack of infection data from China is troubling. Beijing has not updated its daily COVID reports for three days. Although the reduction of tests rendered the data mostly meaningless, the lack of transparency is feeding concerns that the spread of the virus may be worse than the government originally anticipated. One hospital in China reported that half of its 2000 workers were infected with the virus. Meanwhile, local officials in Henan, the country’s third most populous province, revealed that over 90% of the region had been infected. The mystery behind the scale of the spread has led neighboring countries to push for more testing for tourists leaving China.
- A severe outbreak is potentially detrimental to the global economy. A major unknown is how the recent rise in infections could impact consumer psychology. Although it is tempting to believe that things will return to normal after the recent wave, there is also the possibility that people will be much more cautious, particularly when it comes to services. Hence, the recovery may not be as robust as the current market pricing suggests. Spending during the Lunar New Year will likely provide insight as it is one of the year’s biggest shopping periods for China. A sharp increase in sales should boost optimism about China’s recovery.
Berlin Shrugs: Germany may be more open to allowing the U.S. to implement its climate-change subsidies than its comments suggest.
- The European Union is moving to compete against the U.S. in the green energy race. German Chancellor Olaf Scholz is pushing for the EU to create financial instruments to make it easier for countries to provide incentives for green investment. Although Scholz did not explicitly call for EU bonds, he did advocate for joint financing instruments to help budget-strapped countries. The call was in response to the U.S. act that gives tax credits to consumers who buy electric cars made in North America. If the EU were to follow through on the initiative, it could pave the way for stimulus throughout the bloc.
- The possibility of a joint EU venture reinforced investor optimism that a recession within the region will not be as severe as originally thought. The gap between Italian and German 10-year bonds, a gauge of European financial stress, has shrunk by 53 bps to start the year. Meanwhile, the EUR has surged to parity with the CHF and has been able to hold its value against the USD. The improved outlook has encouraged investors to pour in half a trillion dollars to purchase European bonds, suggesting strong demand for more European assets. However, despite Scholz’s tough talk, we are not confident that he is serious about a push for EU-wide investment.
- Although Scholz’s proposal suggests that he supports a pro-European stimulus package, it isn’t clear if it is a genuine plan. In theory, Germany could implement a similar policy unilaterally without EU consent as it did with its controversial energy subsidy. Its unwillingness to do so suggests that it is ambivalent toward the U.S. incentive program. If true, this may disappoint the Biden administration as we suspect it wants the EU to implement a stimulus program supporting European firms. In our view, Washington believes that with increased state action, the EU could become less dependent on China.
- That said, if Scholz follows through on the proposal, the EU will likely create a plan that favors lending and subsidizing firms. This scenario would benefit European equities; however, such a plan could take months or maybe years to implement.