Aurelia Butler

Good morning. It is CPI day, again. When you write a finance newsletter, it feels like the monthly CPI numbers come out about once a week. At least today’s report (and next month’s) are expected to come in cool. It’s an autumnal bounce in inflation most pundits are worried about. Email us with what you are worried about: [email protected] and [email protected] deflation and US inflationIn yesterday’s piece about China tipping into deflation, we showed you the chart below. The blue line is the value of Chinese exports and the pink line is an index of export prices. Price cuts are propping up exports:

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This poses the question: could China export deflation to the US? If you think US inflation will struggle to glide gently down to 2 per cent, owing to high wage growth and resilient consumer spending, importing some Chinese deflation could help. It could act as a positive supply mini-shock, nudging prices lower without harming activity. China’s spare capacity could help sate strong US demand.In a note out this week, Ed Yardeni of Yardeni Research suggests that Chinese deflation may matter to US inflation. He points to how closely US and Chinese consumer inflation co-varied before the pandemic. As pandemic anomalies normalise, could the relationship kick back in? Yardeni’s chart:

Producer inflation in the two countries matches even more closely:

Thierry Wizman, rates strategist at Macquarie, thinks the Federal Reserve could be eyeing Chinese deflation with favour. He wrote yesterday:China’s deflation does have a positive side too, though, if it helps soothe concerns about US and European inflation, as China’s demand puts less of a strain on global supply chains. We suspect that the Fed is looking at international conditions again, and this may be informing the more ‘dovish’ tone we’ve seen emanating since the July 26 [Federal Open Market Committee] meeting.But it’s hard for us to see this mattering much. Paul Donovan of UBS Global Wealth Management makes a persuasive case in the opposite direction. He notes that consumer inflation is an “intensely local affair”. It is hard to do apples-to-apples comparisons between the rich US and upper-middle-income China. Food makes up a bigger share of China’s consumption basket, for example. Here’s Donovan on producer inflation:In theory, [producer prices] are more relevant via the export market to the rest of the world. But remember that most of what is produced in China is actually consumed in China. An awful lot happens to the exports before they are then consumed in an importing country. Generally, most of the price of something made in China that is sold in the United States will be paid to US workers — the transport, distribution, advertising, retail, etc. BCA Research’s Dhaval Joshi adds that the deflation China could in principle export is not the sort that would reassure the Fed. Trade is largely in goods, and the Fed is worried about non-housing services. Even if goods prices fell faster than they are already, it may not sway the Fed anytime soon. There is, alas, “no arbitrage between Chinese deflation and US inflation”, he told us yesterday.One way deflation could matter, though, is insofar as weak Chinese demand keeps a lid on commodity prices, especially oil, which is already up 20 per cent since June. Skanda Amarnath of Employ America, who is generally an optimist on the US economy, thinks further increases in energy costs “would probably be the strongest pathway to recession risk”.All this means that how strongly China stimulates its flagging economy will have global spillovers, including to the US. The recent run-up in oil prices likely reflects, at least in part, expectations for a significant juicing of Chinese fuel demand. If stimulus plans underwhelm, the US could well enjoy some nice energy cost relief. But the risk is two-sided. An aggressive Chinese stimulus could deliver an oil price bump at a very unwelcome time. (Ethan Wu)The flip side of floating rates is credit qualityYesterday we wrote about several large Reits that invest in commercial real estate mortgages. A summary:CRE mortgage Reits tend to have quite conservative financial structures and do not appear primed to blow up.There is an interest rate spread compression problem, though. The Reits make floating-rate loans, but if they were to pass on the entirety of the large increase in interest rates to their borrowers, some of those borrowers would likely break under the strain. So the rate spread — that is, the profitability — at the Reits has not risen as fast as interest rates.Since the Reits’ dividends depend, ultimately, on their rate spreads, those have not risen as fast as rates, either. That means the Reits have to trade at a discount to book value to make the dividends competitive with market rates (the two-year, risk-free Treasury rate is 4.8 per cent!). Market perceptions of CRE risk exacerbates the issue.At the same time, the Reits have to hold more cash to meet their own debt covenants as CRE valuations wobble.But trading at a discount to book value and holding extra cash makes it hard to raise capital and grow.One pitch for CRE Reits was always that they own floating rate assets, and therefore are resilient to rising rates. This has not turned out to be particularly true, and there is an important lesson there. That lesson might be summed up like this: the flip side of floating rates is credit quality.All that said, the biggest CRE mortgage Reits — the ones run by Blackstone, KKR and Starwood — trade at only smallish discounts to book, reflecting the solidity of their business models. It would be remiss of me, however, if I did not mention that there are several CRE mortgage Reits that trade at big, fat discounts to book, and have lost about half their market value since the pandemic began:Expanding yesterday’s table, here are some facts and figures. Look in particular at the third row, price/book:

Granite Point’s discount stands out, and a couple of things are worth noting there. First, the company just took title to a 256,000 square foot office property in Phoenix, against which it previously had a $29mn loan. Second, it announced last week in a regulatory filing that it had come to an agreement with its own lenders — Morgan Stanley, JPMorgan Chase, Goldman Sachs and Citigroup — to loosen some of its loan covenants. The company has said that “the amendments are part of our active balance sheet management and are designed to better reflect the high interest rate environment and better align the [covenant] tests with the current market conditions. This step further reinforces our good standing with our lending partners.” This is undoubtedly true, but when things are going perfectly, mortgage Reits don’t amend their covenants or end up owning office buildings.Granite Point is hardly unique, even if the market assigns it a particularly wide discount. Buildings are being taken back and covenants eased across the industry. The crucial underlying issue is spread compression. In the most recent quarter, Granite Point had a net interest income spread of 0.4 per cent. Two years ago, its spread was 1.7 per cent.The point here is not to argue that the CRE Reit business model is broken or that the high-discount CRE Reits cannot make a comeback. The point is just that (all together now!) the flip side to floating rates is credit quality.One good readWhen the Dalai Lama dies. More

Deposits at the UK’s four biggest banks have fallen by close to £80bn over the past year, as retail and corporate customers look for better interest rates, households grapple with higher costs and mortgage holders pay off loans early.NatWest, Lloyds, HSBC and Barclays experienced total outflows of about £78bn in the 12 months to June 2023, according to an analysis of corporate filings by the Financial Times. That is the largest drop over four quarters since June 2018, the most recent year for which data is available for all of the lenders. While the “big four” still hold close to £240bn more in deposits than they did in 2019, rival lenders’ offer of higher interest rates is forcing them to improve their own deals. “[Retail] customers are migrating from current accounts at the large incumbent banks into savings or fixed-term deposits at some smaller peers,” said Benjamin Toms, analyst at RBC Capital Markets, while “the significant driver in the corporate space is the search for yield from corporate Treasury departments”.Smaller companies would also have repaid government-backed loans issued during the pandemic that had sat unused in their accounts, he said.Toms added: “[Retail] customers have also been using surplus deposits to pay down debt, including both mortgages and credit cards, and generally manage their expenses as a result of a higher cost of living.” Deposits began rising in the final quarter of 2019, jumping by nearly £80bn in the second quarter of 2020 as pandemic curbs hit spending. They peaked at more than £1.5tn in Q2 2022. NatWest’s major drop in the first quarter was partially due to technical reasons, as it exited the Irish market.While smaller lenders benefited from the surge, deposits at the big four rose by 20 per cent in the four years to June, almost twice the average of Santander, Virgin Money UK, Metro Bank and TSB.Holding larger deposits in a period of rising interest rates boosts banks’ net interest margins — the difference between what they offer depositors and what they charge for loans.With interest rates at a 15-year high of 5.25 per cent, lenders have come under mounting pressure over their speed in passing on the benefits of higher interest rates to savers.The House of Commons Treasury select committee last month accused the big four of “blatant profiteering” by “squeezing higher profits from their loyal savings customers”, while the Financial Conduct Authority last week set a deadline for banks to justify low interest rates or face penalties. The FCA and the data watchdog also told lenders in July that they could communicate better savings rates to customers and follow data protection rules, after banks raised concerns over compliance.

High street banks have responded by improving rates on instant access accounts, which now range from 1-1.75 per cent compared with 0.7-1.35 per cent a month ago. But they still lag rivals such as JPMorgan’s Chase UK, which plans to increase its instant access savings rate to 4.1 per cent from next week.One senior executive at a smaller bank said that while rising living costs had contributed to the roughly £78bn outflow, it had largely been driven by consumers withdrawing money to repay mortgages early, in order to defray potential costs from higher rates.“I think some people are saying: ‘My mortgage is getting a bit expensive but I’ve got all this cash in my bank.’ So they’ll repay some or all of it, depending on how much money they have,” he said. BoE data published last month showed that the “effective” interest rate — the actual interest rate paid — on outstanding mortgages increased by 0.1 percentage points in June to 2.92 per cent. The average 2-year tracker rate is now at 6.18 per cent.The central bank also found that households withdrew a net £8.4bn from instant-access “sight” accounts offering interest in June, while they put a net £6.6bn into more competitive, longer-term fixed rate products, which are more costly to banks as the margin is smaller.Katie Murray, NatWest’s chief financial officer, said at the bank’s half-year results in July that a “greater move to interest-bearing assets”, and competition in mortgages, was behind its cut to its net interest margin guidance. More

Gross domestic product (GDP) in the June quarter rose 4.3%, losing further momentum after the previous quarter’s 6.4%, which was slower than the December quarter’s 7.1%. On a quarter-on-quarter basis, the economy contracted 0.9% in the second quarter, weaker than the 1.1% expansion in the March quarter and missing a 0.5% growth forecast of economists.The country’s economic ministers said the weaker performance was due to higher prices of farm goods deterring consumer spending, plus a contraction in government spending compared to the same period a year earlier, when an election was held.”For the second quarter, the moderate economic expansion was driven by increases in tourism-related spending and commercial investments, but was tempered by high commodity prices, the lagged effects of interest rate hikes, the contraction in government spending, and slower global economic growth,” they said in a statement. The slower than expected growth in the second quarter will weigh on the policy review of the central bank, which will meet on Aug. 17 to decide whether to resume raising rates or extend its rate hike pause.The ministers said an improving inflation outlook boded well for an easing of interest rates, and government spending would accelerate in the coming quarters and they aimed to ensure overall price stability amid upside risks. More

The 3.6% rise in the corporate goods price index (CGPI), which measures the price companies charge each other for their goods and services, compares with the median market forecast for a 3.5% annual increase and follows a 4.3% annual increase in June.After peaking at 10.6% in December, wholesale inflation has slowed for seven months in a row, the data showed.The data underscores the Bank of Japan’s view that consumer inflation will slow in coming months as global commodity prices slide from last year’s peak levels.For July, government subsidies to mitigate the impact of the spike in households gas and electricity utility fees, which shaved 0.6 percentage points off the overall increase, helped curb price hikes, the data showed.Yen-based import prices fell 14.1% in July from a year earlier, falling for a fourth straight month, easing concerns about elevated import bills for companies reliant on raw material imports. More

NEW YORK/WASHINGTON (Reuters) -President Joe Biden on Wednesday signed an executive order that will prohibit some new U.S. investment in China in sensitive technologies like computer chips and require government notification in other tech sectors.The long-awaited order authorizes the U.S. Treasury secretary to prohibit or restrict U.S. investments in Chinese entities in three sectors: semiconductors and microelectronics, quantum information technologies and certain artificial intelligence systems.The administration said the restrictions would apply to “narrow subsets” of the three areas but did not give specifics. The proposal is open for public input. The order is aimed at preventing American capital and expertise from helping China develop technologies that could support its military modernization and undermine U.S. national security. The measure targets private equity, venture capital, joint ventures and greenfield investments.Biden, a Democrat, said in a letter to Congress he was declaring a national emergency to deal with the threat of advancement by countries like China “in sensitive technologies and products critical to the military, intelligence, surveillance or cyber-enabled capabilities.” China said on Thursday it is “gravely concerned” about the order and that it reserves the right to take measures.The order affects normal operation and decision-making of enterprises, and undermines the international economic and trade order, a statement from the Chinese Commerce Ministry read.The minisry also said it hopes the U.S. will respect laws of the market economy and the principle of fair competition, and refrain from “artificially hindering global economic and trade exchanges and cooperation, or set up obstacles for the recovery of the world economy”.SEMICONDUCTORS A PRIORITY The proposal focuses on investments in Chinese companies developing software to design computer chips and tools to manufacture them. The U.S., Japan and the Netherlands dominate those fields, and the Chinese government has been working to build homegrown alternatives.The White House said Biden consulted allies on the plan and incorporated feedback from Group of Seven nations. “For too long, American money has helped fuel the Chinese military’s rise,” said Senate Democratic Leader Chuck Schumer. “Today the United States is taking a strategic first step to ensure American investment does not go to fund Chinese military advancement.” The regulations will only affect future investments, not existing ones, Treasury said, but it may ask for disclosure of prior transactions.The move could fuel tensions between the world’s two largest economies. The Chinese embassy in Washington said it was “very disappointed” by the measure. U.S. officials insisted the prohibitions were intended to address “the most acute” national security risks and not to separate the two countries’ highly interdependent economies.Republicans said the order was rife with loopholes, such as only applying to future investment, and was not aggressive enough. SOME EXEMPTIONS EXPECTEDThe order will prohibit some deals and require investors to notify the government of their plans on others.The Treasury said it anticipates exempting “certain transactions, including potentially those in publicly traded instruments and intracompany transfers from U.S. parents to subsidiaries.”The Chinese tech industry, once a magnet for U.S. venture capital, has already seen a drastic decline in U.S. investment amid intensifying geopolitical tension.Last year, total U.S.-based venture-capital investment in China plummeted to $9.7 billion from $32.9 billion in 2021, according to PitchBook data. This year so far, U.S. V.C. investors only put $1.2 billion into Chinese tech startups. The measure is expected to be implemented next year, a person briefed on the order said, after multiple rounds of public comment, including an initial 45-day comment period.REPUBLICAN SEES MANY LOOPHOLES Republican Senator Marco Rubio said the Biden administration’ plan was “almost laughable.””It is riddled with loopholes, explicitly ignores the dual-use nature of important technologies, and fails to include industries China’s government deems critical,” he said.A spokesman for the Chinese embassy in Washington said the White House had not heeded “China’s repeated expression of deep concerns” about the plan. The spokesman said more than 70,000 U.S. companies do business in China. The restrictions will hurt both Chinese and American businesses, interfere with normal cooperation and reduce investor confidence in the U.S., he said. The Semiconductor Industry Association said it hopes the order will enable “U.S. chip firms to compete on a level-playing field and access key global markets, including China.”Emily Benson of the Center for Strategic and International Studies (CSIS), a bipartisan policy research organization, said key questions are how the plan affects U.S. allies and how China responds. More