Aurelia Butler

Good morning. Ethan here; Rob returns tomorrow. Is all the good news priced in already? So far this earnings season, the median price reaction to an earnings beat has looked limp versus history, according to Morgan Stanley. One notable exception: Berkshire Hathaway, which rose 3.4 per cent after Saturday’s earnings, and after Unhedged wrote that Berkshire probably can’t sustainably beat the S&P 500. Readers can decide which seems the likelier catalyst. Email me: [email protected] effects and the inflation threatHere is a dumb point about inflation “base effects” that’s nonetheless easy to mix up. Inflation is a rate of change, so the denominator you choose to measure it with makes a big difference. The two standard methods are month-over-month and year-over-year comparisons. What’s tricky is that you can have flat monthly rates alongside rising annual rates. Whatever happened to prices a year ago ripples over to today.Though this point is fiddly, it matters. Because the sharpest inflation increases happened in the first half of 2022, annual comparisons for the rest of this year’s CPI reports will be boosted by more slowly rising denominators. The dominant soft-landing market narrative is anchored in part by the pretty little 3-handle on current headline annual inflation. If this starts rising, even if it reflects a tame monthly rate, investors could begin doubting their assumptions about how immaculate disinflation will be.This basic point is made in a recent post by Rob Arnott and Omid Shakernia of Research Affiliates. Earlier in the year, they forecast “an illusion of tumbling inflation in the first half of the year, perhaps even falling below 3 per cent by mid-year, then an illusion of soaring inflation in the second half of the year”, driven by shifting base effects. They illustrate why in the chart below, first published in January. The orange line shows how high annual inflation could conceivably rise, assuming flat monthly CPI readings at 46 basis points (the 2020-23 average). The green line shows the lower bound, with monthly readings at zero throughout 2023:

A 46bp monthly print is unlikely, as Arnott and Shakernia concede. (The 2023 monthly average so far is 27bp.) Even still, they think year-over-year headline inflation could finish the year in the range of 4-5 per cent, starting with Thursday’s July CPI report. From their post:Suppose, for example, that we see an average of 20-40 basis points of inflation each month through year-end. Then we should see the year-over-year inflation rise to somewhere between 4% and 5½% by year-end. That’s enough to be alarming to most observers, who are typically not paying attention to the low rates of inflation that we are replacing late 2022.We find it a bit amusing that, if inflation finishes the year at half its peak levels of mid-2022, this will be an adverse shock to many (indeed, likely most) investors. If we finish the year at 4½% inflation, we will be pleased by this usually benign denouement following a dangerous inflationary surge, but most of the investment community, media, and political elite will likely be alarmed (fear sells!).Research Affiliates is not the only shop thinking about this. Bank of America’s chart below received a good deal of attention back in July. It shows where yearly inflation would go assuming a few different flat monthly rates (the chart is misleading; more on that below):

Omair Sharif of Inflation Insights has a beef with BofA. Their chart’s title suggests that any monthly inflation reading above 20bp would push up annual headline rates. That would seem a low bar, raising fears of a base effects-driven inflation resurgence. But Sharif points out that BofA misleadingly uses non-seasonally adjusted monthly rates. If you use more conventional seasonally adjusted numbers instead, base effects look much less threatening. The real bar for monthly rates creating inflation re-acceleration is more like 40bp. Here is Sharif’s redo of BofA’s chart:Base effects should be easy enough to ignore in the next few months because, as Carl Riccadonna, chief US economist at BNP Paribas, pointed out to me yesterday, “when we talk about base effects we’re basically talking about energy base effects”. Watching core inflation, even in year-over-year terms (currently at 4.9 per cent), will probably give you a better idea of where inflation is heading. But in general, “for the next couple months, you shouldn’t be too focused on the year on year trend”, he added.So, all good then? Not entirely. Rather than a sharp inflation rebound, the problem is if inflation settles in at an uncomfortably high rate. Over the next couple months, we will probably see encouraging monthly core inflation readings around 20bp, thanks to disinflation in shelter and used cars. But Sharif thinks the next 12 months will look more like core inflation pinging between 20bp and 30bp, somewhere between the high-2s and 4 per cent in annualised terms. Over at The Overshoot, Matt Klein makes the case that it’ll look more like 4:Without a downturn, it is unclear whether (or why) wage growth would decelerate enough from here to bring inflation all the way back to the Fed’s 2% yearly goal over any reasonable timeframe . . . The main reason to worry is that nominal wages have consistently been rising about 5%-6% a year since last summer . . . Since consumer spending tracks wage growth better than anything else, real volumes of goods and services would have to rise about 3%-4% a year for the current pace of wage increases to be consistent with 2% inflation. That would certainly be my preference, and there are good reasons to think that productivity might accelerate, but the likelier outcome is that underlying inflation is closer to 4% than 2%.This is the hole in the soft landing story: persistently high wage growth sustaining consumer spending. In lieu of slower wage growth, falling prices may just increase consumer purchasing power, lifting demand in a way that, ultimately, shows up as higher prices.Sharif gives a vivid example from the used-car market, in principle one of the most rate-sensitive parts of the economy. In the last six months of 2022, used-car prices fell steadily. Then, in January, demand popped. Driven by lower prices (and substitution from new cars), retail used-car sales shot up 10 per cent in just one month. The surge in demand “caught all the dealers off guard”, forcing them to rush to wholesale auctions, says Sharif. Three months later, that mad dash showed up in inflation. The used cars and trucks CPI sub-index rose more than 4 per cent in April and May.Used cars are an especially dramatic category, and probably unrepresentative. But the point is that inflation can only fall as far as consumer spending lets it. The inflation threat to markets has not gone away.One good readA very nice book review considers the gap between George Orwell’s rhetoric and his life. More

Imports from China to the EU, including of sensitive technology and critical minerals, have increased in recent years, despite lawmakers’ attempts to “de-risk” economic links amid deteriorating diplomatic relations with Beijing.Brussels labelled China a “systemic rival” in 2019 after trade tensions between the two economic superpowers increased. However, Eurostat data shows that the value of goods coming from the world’s largest exporter almost doubled between 2018 and 2022.During the first half of this year, China has remained by far the largest supplier of goods to the EU.An OECD analysis shows imports of items such as phones, computers and machinery have all risen sharply over the period despite EU officials’ concerns that China could use the technology to procure state secrets. China is also the EU’s largest supplier of rare earths and other critical raw materials.“China has very successfully convinced the major industrial economies to put many of their eggs in the Chinese basket . . . it is devilishly difficult to fully extricate themselves from their predicament,” said John Blaxland, professor of international security and intelligence studies at the Australian National University.The China problem has drawn concern from officials in Brussels. EU trade commissioner Valdis Dombrovskis told the Financial Times in an interview published on Monday that the “staggering” deficit between the EU and China underscored the need for Beijing to open its markets.

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“The China-EU trading relationship is very imbalanced,” said Dombrovskis. “The level of openness from the Chinese side is not the same as the level of openness from the EU side.”Yet EU officials increasingly accept that breaking ties with an economy that accounts for 14 per cent of global goods exports will prove difficult.European Commission president Ursula von der Leyen acknowledged this year that the bloc could not fully “decouple” from trading with Beijing. It would instead “de-risk” its economy by producing goods deemed important for national security within the EU.A summit of EU leaders last month concluded that Brussels and Beijing would “continue to be important trade and economic partners”, despite the bloc reducing “critical dependencies and vulnerabilities”. The EU did not intend to “turn inwards”, the statement said.“Decoupling is not feasible, short of war,” said Blaxland.

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However, OECD figures show the US has made far more progress in becoming less reliant on its main economic rival. Between 2018, when then-president Donald Trump imposed 25 per cent tariffs on $34bn-worth of Chinese imports, and 2022, US Trade data show the share of imports coming from China fell from 21 per cent to 16 per cent. Despite a more co-operative tone, President Joe Biden has not removed the trade barriers, and the declines have continued this year, according to Census Bureau data. But US companies’ ties may still be closer than the official data suggests. Chinese businesses used as suppliers before the tariffs were introduced have since moved parts of their operations elsewhere in Asia to comply with the rules.“All we know from that data is that the source of final assembly before it comes to the United States is changing,” said Chad Bown at the Peterson Institute for International Economics think-tank. “It could be the same firms that were doing that final assembly in China are now just doing it in Vietnam or Cambodia or Bangladesh or Thailand instead.”

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Some analysts said the EU had stepped into gaps left by the US, after Beijing lowered tariffs directed towards European countries in response to the US trade war.European carmakers’ sales to China have boomed since US companies were shut out of the market. Last year alone, the relationship was worth €24bn.The greatest threat to this business may come not from trade wars, but the rise of Chinese carmakers — a sector that is becoming so successful it is taking European manufacturers’ market share at home and abroad.Three of Europe’s best selling electric vehicles last year were Chinese imports, accounting for 3-4 per cent of total European car registrations — up from zero a few years ago. Sales of Chinese-made cars in Europe could reach 1.5mn vehicles by 2030, equivalent to 13.5 per cent of the EU’s 2022 production, according to Allianz.France has responded by introducing legislation to only pay subsidies for new EVs based on the emissions of their producers, which will hit Chinese carmakers that rely on electricity largely powered by coal.Germany, the bloc’s car powerhouse, unveiled its “de-risking” strategy last month, with foreign minister Annalena Baerbock warning companies to reduce their dependence on China or “bear more of the financial risk themselves”.“The debate in Germany is shifting quite rapidly towards a much more critical and concerned attitude towards trade and investment in China,” said Marianne Schneider-Petsinger, project director at Chatham House’s Global Trade Policy Forum. “But at the same time, there is a difference between firms on the ground and the government.”Additional reporting by Sam Fleming in Brussels and Martin Arnold in Frankfurt More

MUMBAI (Reuters) – India’s monetary policy committee (MPC) is expected to maintain key rates when it meets on Thursday, but will adopt a far more hawkish tone as the recent rise in food prices risks becoming entrenched, economists and market participants said. A July 13-31 Reuters poll of 75 economists showed the central bank was expected to keep its repo rate unchanged at 6.50% at its Aug. 10 policy meeting. Food price spikes in India, typical at the onset of the monsoon, drove up headline inflation in June, corroborating the MPC’s view that the fight against inflation is far from over, the Reserve Bank of India (RBI) said in its bulletin last month.The rise in food prices, however, has been sharper than expected this year and is seen lasting longer. “It’s likely that the hawkish rhetoric will be dialled up further in the MPC meeting,” Shilan Shah, deputy chief emerging markets economist at Capital Economics said.DBS Bank expects the evolving inflationary trend to pose a 80-100 basis points (bps) upside risk to the MPC’s current inflation forecast of 5.2% for the September quarter. June CPI rose 4.81%, snapping a four-month easing trend, with economists expecting the July print, due on Aug. 12, to top 6% levels, moving out of the RBI’s 2%-6% inflation comfort band.The MPC at its June policy meeting also reiterated its intent of nudging inflation towards its medium-term target of 4% and not just holding it below 6%. DBS said not only are rate cut expectations getting priced out, but the OIS curve appears to be pricing for around a 40-50% likelihood of a 25 bps hike over the next two RBI meetings.Economists at ANZ also agreed with that view.”There is therefore greater reason for the RBI to sound more hawkish at its upcoming meeting, even if it will likely keep the repo rate unchanged,” they said.”It will also possibly emphasise a larger need to be watchful of the second-round effects of high food prices and inflation expectations.”A majority of the economists polled said rates will stay at 6.5% through the first quarter of 2024, followed by 50 basis points worth of cuts by the end of June, around the same time when markets expect the U.S. Fed to start cutting its rates.”The bond market will take cues from the RBI’s assessment of the current spike in food prices and its impact on the overall inflation outlook and monetary policy,” said Pankaj Pathak, Fund Manager- Fixed Income, Quantum (NASDAQ:QMCO) AMC. More

TOKYO (Reuters) -Japanese real wages fell for a 15th straight month in June, while nominal pay growth also slowed, suggesting companies will need to do more on salary hikes to drive a virtuous growth cycle and allow the central bank to consider exiting easy policies.Separate data on Tuesday showed Japan’s consumer spending shrank for the fourth month in June, underlining the challenge facing policymakers as the economy remains underpowered despite the end of COVID curbs months ago.Japan’s wage trends are closely watched by global financial markets as the Bank of Japan has emphasised that sustainable pay hikes amid four-decade-high inflation is a prerequisite for dismantling its massive monetary stimulus.”Japanese wage growth tends to stall once annual spring wage negotiations are over – the rise we’re seeing isn’t strong enough to boost consumption and achieve (BOJ’s) 2% inflation target,” said Takeshi Minami, chief economist at Norinchukin Research Institute.Inflation-adjusted real wages, a barometer of consumers’ purchasing power, fell 1.6% from a year earlier, a faster decrease than May’s 0.9% drop, extending a streak of contractions since April 2022.That was because a 2.3% nominal increase in total cash earnings, or nominal wages, was far outpaced by 3.9% consumer price inflation under a measure the ministry uses that excludes owners’ equivalent rent.Nominal pay growth in June was lower than a revised 2.9% rise in May, the fastest growth in nearly three decades thanks to solid jump in base salaries. June’s base salary increase was 1.4%, also smaller than May’s 1.7%. “That means that regular wage growth has yet to surpass 2%, which the Bank of Japan considers necessary for above-target inflation to be sustained,” Marcel Thieliant, Capital Economics’ Head of Asia Pacific, wrote in a note.Workers at major Japanese companies saw an almost 4% wage hike this year, according to a survey by elite business lobby Keidanren, while the country’s National Personnel Authority on Monday advised the central government to hike its workers’ base pay 10 times more than the average in the previous five years. There are signs of broadening wage hikes. A government panel last month approved the biggest-ever increase in the national minimum wage. A July survey by research firm Teikoku Databank showed on Monday that 51.4% of companies across Japan were experiencing a shortage of regular workers, near the historical high of 53.9% seen in November 2018.Overtime pay, a gauge of business activity strength, rose 2.3% in June, the fastest in six months, health ministry data showed. Special payments, including summer bonuses, rose 3.5%.WEAK CONSUMPTION Separate government data showed household spending fell 4.2% in June from a year earlier, a fourth month of decline and in line with a median market forecast. Although items such as cars and travel expenses grew, the downturn in food and household electronics led the overall decrease.On a seasonally adjusted, month-on-month basis, household spending increased 0.9%, against forecast for a 0.3% gain.Real wages will continue to shrink and squeeze consumption until next April or later, Norinchukin’s Minami said, attributing it to sticky consumer inflation and the yen’s decline. Nominal wage growth itself may slow next year, he added.”If the Japanese stock market couldn’t keep up with the current rally and companies record not-so-great earnings, then the momentum for further pay hikes may be lost.”($1 = 142.2100 yen) More

The Westpac-Melbourne Institute index of consumer sentiment dipped 0.4% in August from July, when it bounced 2.7%. The index reading of 81.0 showed pessimists again outnumbered optimists, a level that used to be only associated with recessions.A slowdown in consumer spending is one reason the Reserve Bank Australia (RBA) held rates steady at 4.1% last week, though it cautioned that it might yet have to hike further to bring inflation to heel.”The survey detail pointed to little or no impact from the RBA’s decision to pause,” noted Westpac senior economist Matthew Hassan. “Responses showed no improvement over the course of survey week, sentiment instead declining 4.9% between those surveyed prior to the RBA decision and those surveyed after.”Two thirds of respondents still expected rates to rise over the year ahead, pushing sentiment among mortgage holders down a sharp 7.2%.The survey’s measure of economic conditions over the next 12 months dropped 4.0%, while the outlook for the next five years dipped 0.8%.The mood was a little brighter on family finances, which rose 3.4%, while a measure of whether it was a good time to buy a major household item edged up 0.3%.Consumers were much more downbeat on whether it was a good time to buy a house, but also bullish on prices as that index hit its highest for the year so far. More