UK Inflation: Defying Gravity

The UK is in a bit of a pickle, with new data last week showing headline inflation refused to come down in May. Even worse, core inflation accelerated to a 30-year high. That prompted the Bank of England to deliver a bigger-than-expected 50-basis-point hike last Thursday, with traders now betting that UK interest rates will peak at around 6% by early next year. But if that happens, the British economy could be in for a recession, according to a new analysis by Bloomberg. Things were quite the opposite in China, with lenders in the country following the central bank by lowering borrowing costs last week. After all, the economy desperately needs a boost, with several investment banks slashing their growth forecasts for 2023.

Speaking of China, pharmaceutical giant AstraZeneca is drawing up plans to break out its business in the country and list it separately in Hong Kong or Shanghai, according to an FT report last week. The move could be a sign of what’s to come, with many other multinational corporations potentially being forced to undertake similar restructurings as they adapt to rising geopolitical tensions between China and the West. Finally, an interesting development happened in the US last week, with the yields on cash, bonds and equities all the same for the first time ever. Find out more in this week’s review.

Macro

After a strong start to the year, China’s economy has started to lose some steam, raising doubts about its recovery following years of strict Covid-related restrictions. Data out earlier this month, for example, showed retail sales, industrial production, and spending on construction and machinery all weakened more than expected in May from April. That prompted the Chinese central bank to slash its short-term and medium-term interest rates in mid-June, marking the first rate cuts since August 2022. And last Tuesday, Chinese banks followed the central bank by lowering their benchmark lending rates after nearly a year of flat borrowing costs. The one-year and five-year loan prime rates were cut by 0.1 percentage points each to 3.55% and 4.2% respectively. That’s set to lower the cost of borrowing for businesses and households, and hopefully give the Chinese economy a much-needed boost.

Investors were slightly disappointed with the announcement as they were hoping for a 0.15-percentage-point cut to the five-year rate, since it’s linked to mortgages and would help prop up the country’s struggling property market. After all, the real estate sector accounts for about 30% of China’s economy and has been a major drag on growth this year. That’s why many analysts are calling for more measures to revive the property sector, including lifelines for cash-strapped developers and government incentives aimed at reducing mortgage down payments.

But in the absence of such measures, economists are becoming increasingly pessimistic about China's growth prospects this year, with several major investment banks recently lowering their forecasts. JPMorgan cut its 2023 economic growth projection to 5.5% from 5.9%, UBS to 5.2% from 5.7%, Nomura to 5.1% from 5.5%, Standard Chartered to 5.4% from 5.8%, and Goldman Sachs to 5.4% from 6%.

Over in the UK, new data out last week showed the country's inflation rate has once again surpassed expectations. UK inflation remained stuck at 8.7% in May, higher than estimates of a drop to 8.4% and marking the fourth month in a row that price rises have exceeded forecasts. Used car prices along with airline tickets and the cost of recreation and culture drove a lot of the increase. That left Britain as an outlier among major economies with consumer prices rising more than four times faster than the central bank’s 2% target.

But here’s where things got really worrying: core inflation, which excludes volatile food and energy components to give a better idea of underlying price pressures, unexpectedly accelerated in May to a fresh 30-year high of 7.1% from 6.8% the previous month. Economists had expected core inflation to remain unchanged from April. Services inflation, meanwhile, also increased to 7.4% – up from April’s 6.9% and marking the highest rate in over 30 years.

The worse-than-expected inflation report prompted the Bank of England (BoE) to deliver a surprise half-point increase last Thursday, taking interest rates to 5% in its 13th consecutive rate hike and warning of more to come. Traders are now betting that UK interest rates will peak at around 6% by early next year, as the BoE continues hiking borrowing costs aggressively to crush inflation.

Problem is, those higher rates will crush the economy too: according to an analysis by Bloomberg last week, the British economy would shrink about 0.3% this year and by 1.4% in 2024 if the BoE pushes interest rates to 6% as investors expect. That would also push up the country’s government-debt-to-GDP ratio, which just rose above 100% for the first time since 1961 according to a separate report out last week. A soaring ratio is concerning because not only does it strain public finances, but also makes it harder for the government to implement tax cuts or other forms of fiscal stimulus, limiting its ability to stimulate the economy in the future, if necessary.

Stocks

According to a report last week by the Financial Times, AstraZeneca – the UK’s biggest listed company by market value – is drawing up plans to break out its China business and list it separately in Hong Kong or Shanghai. The proposed plan would have AstraZeneca spin off its China operations, which accounted for 13% of the company's total revenue last year, into a separate legal entity but would retain control of the business.

There are a few reasons behind the plans. First, it would offer AstraZeneca a new, separate source of capital to fund growth in China – an attractive market for pharmaceutical companies because of its large and aging population, which is increasingly suffering from diseases caused by smoking, pollution, and westernized diets. Second, a domestic listing could help the firm win faster approvals for drugs developed in China. Third, it could insulate AstraZeneca’s China business from moves by Beijing to crack down on foreign companies amid rising frictions between China and the West. It would also reassure investors in the remaining company that they had less exposure to China-related political risk.

AstraZeneca’s move could be a sign of what’s to come, with many other multinational corporations potentially being forced to undertake similar restructurings as they adapt to growing geopolitical strains. In fact, according to one Asia-based banker, every multinational with a strong presence in China has already considered a similar move. Just look at venture capital powerhouse Sequoia Capital, which announced earlier this month that it’s breaking up into three entities around the world, splitting the Chinese and US operations as tensions grow between the world’s two biggest economies.

Elsewhere, an interesting development has happened in the US: the steep surge in interest rates, coupled with the recent impressive performance of the stock market, has left the yields on cash, bonds, and stocks the same for the first time ever. Cash in the form of three-month US Treasury bills is currently yielding 5.2%, after the Fed held interest rates at between 5% and 5.25% but hinted at two additional quarter-point increases this year. That’s roughly the same level as the 5.1% expected 12-month forward earnings yield on the S&P 500 and the 5.2% yield on investment-grade corporate bonds.

In short, cash is looking very attractive in relation to corporate bonds and stocks, reducing the incentive of owning each. After all, if investors can earn as much in risk-free cash as they can on a riskier corporate bond or an even riskier stock, then they might as well shift some of their money away from stocks and corporate bonds – and into cash. And historically, that’s been a bad omen for stocks, with a shrunken yield gap preceding many of the previous stock market corrections.

This week

• Monday: German Ifo survey for June (a closely watched business climate index that acts as an early indicator of morale in German industry).
• Tuesday: US durable goods orders (May), Canadian inflation (May), US new home sales (May), US consumer confidence (June).
• Wednesday: Australian inflation (May). Earnings: Micron Technology.
• Thursday: Japanese retail sales (May), eurozone economic sentiment (June), US pending home sales (May). Earnings: Nike.
• Friday: Japanese unemployment rate (May), eurozone flash CPI (June), eurozone unemployment rate (May), Canadian monthly GDP (April).