What divergent US and China tacks on inflation mean for investors

MANAGING inflation presents a tricky conundrum for central banks, with major implications for economic growth and capital investment. It is about setting an interest rate level that keeps the speed of price rises reasonable while allowing for healthy growth, with government spending and tax policies playing a supporting role.

But striking that balance is far easier said than done – as is clear from the starkly different situations now facing the world’s two biggest economies, and their respective responses.

There looks set to be another year of disinflation – slowing price rises – in the US, although the oil price recently exceeding US$95 has raised a few doubts. For China, though, the deflation – actual falling prices – that arrived last month could stretch into 2024.

Over the past 12 months, America’s consumer price index (CPI) headline inflation has plunged year on year from 9 per cent to 3 per cent. This is the fastest drop – apart from outright deflation – since the early 1950s.

This came on the back of 11 consecutive rate rises starting in early 2022, to between 5.25 per cent and 5.5 per cent.

On Thursday (Sep 21) the Federal Reserve paused hikes for only the second time this year, but indicated it expected one more rise this year and fewer cuts in 2024 than previously forecast. Fed chairman Jerome Powell said the central bank wanted to see more progress on fighting inflation.

In China, by contrast, inflation is way too low – indeed, it has just turned negative. Consumer prices fell 0.3 per cent in July from a year earlier, in the first instance of deflation since the depths of the Covid pandemic in early 2021.

China’s hesitant response

For a government generally quick to take decisive action to address market or economic issues, Beijing has been somewhat hesitant in its response.

It has cut red tape and introduced consumer-friendly regulations, but avoided pulling the levers of interest rates and central government spending with the same gusto as in previous episodes where deflation threatened.

True, mortgage rates have been cut in the last couple of weeks, but it does not feel like these actions have sparked the same level of shock and awe as previous responses.

Admittedly, China also has other significant worries to weigh – not least record youth unemployment, a shrinking population, a deepening property-sector crisis and still-tightening Western trade restrictions. These will inevitably, and rightly, affect the government’s approach to inflation measures.

Looking ahead, the market is implying that disinflation will continue in the US through the next 12 months. This is supported by various key data points.

First, future price curves for pertinent energy futures contracts, weighted according to consumption, imply they will remain negative on a year-on-year basis for the next six months.

Second, Man Solutions’ gauge of semiconductor prices is down about 20 per cent year on year. This is important, as the industry often represents a key bottleneck in global supply chains.

As for housing, while the CPI rental component is still up 8 per cent year on year, data provider Zillow’s measure is “only” 4 per cent and ApartmentList’s is down 1 per cent. Our rule of thumb is that the official measure follows these “front book” gauges by 12 months, so significant disinflationary pressure seems likely from the rental segment.

Finally, wage growth also appears to be on the downtrend. The quitting rate – the proportion of voluntary job leavers – falling from 3 per cent to 2.3 per cent would historically be consistent with wage growth falling from 5.7 per cent to 4.5 per cent over the next nine months.

The only real outlier is the price of food, where our measure – which combines agricultural commodities contracts with forward revenue estimates for major food retailers – is close to 20 per cent higher year on year.

What is the upshot of continued disinflation in the US? A positive environment for risk assets, at least.

More specifically, the clear winners should be strategies focused on duration, trend-following, value and cross-sectional momentum. Other investments that should provide decent returns are broad equities, consumer discretionary names and investment-grade credit.

In such an environment, though, it would be prudent to avoid picking energy names, favouring large-caps over small-caps, or buying gold.

Fears overdone

In China, meanwhile, the recent turn to headline deflation sparked much weeping and gnashing of teeth. Bank of America’s China Risk-Love measure, for instance – which combines a slew of sentiment, positioning and flows data – recently breached its “panic” threshold.

The gauge has reached this point on 13 prior occasions in the last 25 years. Each time, in the subsequent 12 months, the median performance for MSCI China was plus 25 per cent, with a positive hit rate of 85 per cent.

In the short to medium term, such sentiment may present an opportunity to be contrarian, as the pessimism may have gone too far.

China’s headline-grabbing deflation read is largely a function of base effects from commodity price volatility.

The spread between its rate of inflation and those in developed markets is driven by the fact that there simply was not the same level of money supply growth from pandemic stimulus programmes as in the West. Broad money growth in China peaked at 15 per cent year on year. In the US, it approached over 30 per cent.

The decade-and-beyond view on China is a different matter. The country clearly faces significant structural issues with implications for inflation. Not least of these is a shrinking working-age population, which could cause significant inflationary pressure globally as the availability of labour tumbles.

Investors will be watching closely for the outcome of the two superpowers’ strategies on inflation, although which proves more prescient may not be clear for some time yet.

The writer is portfolio manager of Man Solutions