Inflation is when you pay fifteen dollars for the ten-dollar haircut you used to get for five dollars when you had hair. -Sam Ewing
The Dawn of Disinflation in China
Across the OECD, consumer price inflation (CPI) is on a rapid decline. The anticipation is that the rate will eventually return to levels that appease the central bankers. The belief is such that inflation may not swiftly escalate to 2%, but a speedy ascent to 3% could be on the horizon, prompting central bankers to initiate an ease.
Contrastingly, China’s scenario is strikingly different. Chinese producer price inflation (PPI), a robust leading indicator of CPI, made a descent into the negative territory over 12 months ago and has continued to replunge. Consequently, Chinese CPI has undergone a dramatic plummet and recently morphed into negative territory as well.
China’s battle with deflation raises a myriad of questions and constitutes a crucial piece of the puzzle. For many years now, China has been a deflation exporter. The renewed plunge of Chinese inflation not only raises questions but is also poised to facilitate central bankers in the OECD, keen on further lowering their own country/region’s CPI.
A Glimpse into the 60/40 Portfolio Trend
Despite the less-than-dazzling performance of US equities from a broader perspective last year, they still held up rather well. The S&P 493 delivered a commendable +14%, while the Magnificent 7 achieved an astounding +76%, as indicated in Exhibit 1 below.
Although earnings saw marginal growth compared to equity prices, the 2024 EPS estimates were downwardly revised. As a result, P/E multiples expanded throughout the year, with Q3 being a noticeable exception.
However, an in-depth analysis reveals that despite the seeming overvaluation of most megacap stocks, the US stock market is priced relatively in line with long-term averages, providing investors with important insights.
As the year progresses and inflation continues to moderate, the expectation is for bond yields to further decline. This raises the question of whether we are on the cusp of a favorable year for both bonds and equities, giving rise to a potential win-win scenario for 60/40 portfolios.
Anticipation is that, given a soft landing (as the base case), bonds and equities should fare relatively well, hinging on the continued cooperation of inflation. However, the ultimate outlook hinges on the underlying strength of the economy.
A Minor Disruption in the Shipping Sector
Considerable attention has been lavished on the shipping disruption resulting from the repeated missile strikes by Houthi rebels on commercial ships navigating the Red Sea. However, in reality, this predicament appears to be a mere tempest in a teacup.
Despite the evident rise in shipping costs between Asia and Europe due to a steep surge in insurance charges, a deeper analysis reveals that the impact on inflation is negligible. Research by Goldman Sachs indicates that the resulting impact on CPI is less than 10 bps – hardly significant enough to warrant concern.
Despite initial concerns, it is apparent that the Houthi rebels’ actions won’t significantly alter the overall inflation trajectory. Employment costs are finally coming under control, mortgage costs have begun to moderate, and shelter inflation has reverted to pre-pandemic levels. All things considered, the inflation landscape appears much more felicitous compared to the same time last year.
A Final Reflection
With the synchronized decline in the inflation rate across the OECD, it is reasonable to anticipate that most OECD central banks will commence cutting policy rates later this year. This, in turn, should lead to a drop in yields on longer-dated OECD bonds. Additionally, a resilient response is expected from OECD equity markets, assuming a soft landing – particularly in the US.
The principal risks on the horizon this year are inherently geopolitical. An inordinate number of troublemakers occupy positions of power or are on the brink of ascension worldwide. Significantly, political stability is a crucial prerequisite for buoyant financial markets, a factor that is currently in short supply.
As numerous armed conflicts continue to unfold globally – from Ukraine to Gaza, Pakistan to Jordan, and even within the EU – the overall trend is undeniably disconcerting. Despite the human toll, a modest risk is foreseen of these conflicts considerably impacting G10 corporate earnings in a detrimental manner.
Niels C. Jensen
Original Post
Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.
