A Tale Of Three Inflation Stories

Last week saw data releases that painted three very different inflation stories in China, the US, and the UK. China is teetering on the verge of deflation – a harmful outcome as it leads to decreased consumer spending, lower investment, and potential economic stagnation. Inflation in the US, meanwhile, continues to head in the right direction, with June’s annual rate hitting its lowest level since March 2021. But over in the UK, new data out last week showed wages growing at a record pace, raising the likelihood of a concerning scenario characterized by spiraling inflation. This is where strong wage growth leads to increased spending and higher inflation, which pushes employees to demand even higher wages, and so on.

Elsewhere, investors expect the current earnings season to hurt stocks due to an uptick in profit warnings, according to a recent survey conducted by Bloomberg. What’s more, over 70% of the survey participants reckon that the impact of AI on tech earnings is overblown. Still, that hasn’t stopped Morgan Stanley from predicting that AI-driven gains will elevate Microsoft to join Apple in the exclusive group of stocks with a market capitalization exceeding $3 trillion. As if Big Tech needed to get any bigger: six mega-cap tech stocks now comprise more than 50% of the Nasdaq 100 – way too high for the provider’s liking. That’s why Nasdaq announced last week that its flagship stock market index will undergo a “special rebalance” – the first of its kind – to address the benchmark’s overconcentration. Find out more in this week’s review.

Macro

According to new data released at the beginning of last week, inflation was nonexistent in China in June, with consumer prices unchanged last month compared to a year ago. That was the weakest showing since February 2021, when slumping pork costs dragged on the index. On a month-on-month basis, consumer prices declined by 0.2%. What’s more, producer prices, which reflect what factories charge wholesalers for products, slumped 5.4% in June from a year ago – the deepest pace since December 2015.

Both gauges add to evidence that China’s economic recovery is weakening and are raising concerns that the country could slide into deflation – a harmful outcome as it leads to decreased consumer spending, lower investment, and potential economic stagnation. Aside from a brief period of deflation in early 2021, China hasn’t experienced prolonged consumer price deflation since 2009 amid the global financial crisis. Back then, the government introduced a $553 billion stimulus package focused on infrastructure and industry upgrades. That’s why last week’s poor inflation data is fueling further speculation that the government will soon have to announce stimulus measures to prop up the economy, and that China’s central bank will have to again cut interest rates.

But do you know who does have an inflation problem? The UK. See, the latest CPI report showed the country’s headline inflation rate refused to come down in May. Even worse, core inflation accelerated to a 30-year high. And now, new data out last week showed average wages excluding bonuses in the UK grew at their joint-fastest rate on record in the three months to May, rising by 7.3% from the same period last year. Wages including bonuses increased by 6.9%. Both figures topped economists’ estimates of 7.1% and 6.8% respectively.

The strong showing raises the likelihood of a concerning scenario characterized by spiraling inflation. This is where rising prices of goods and services push employees to demand higher wages, which leads to increased spending and higher inflation. This only gets worse as companies raise the prices of their goods and services to offset higher wage costs. This loop leads to higher and higher (i.e. spiraling) inflation. In fact, the Bank of England (BoE) has repeatedly warned that high wage growth remains a big obstacle to its efforts to lower inflation, and last week’s figures only add to the evidence that the labor market is running too hot. The interest rate futures market now shows traders expect the BoE to raise rates by another 150 basis points by March, which would take its key rate to 6.5%. That compares with an expected peak interest rate of around 4% for the ECB and around 5.5% for the Fed.

Across the pond, the US is celebrating instead, as inflation in the world’s biggest economy continues to head in the right direction. According to the latest CPI report released last week, consumer prices in the US increased by a less-than-expected 3% in June from a year ago – the smallest advance since March 2021 and a sharp drop from the 4% surge registered in May. Core inflation, which strips out volatile food and energy components, fell from 5.3% in May to 4.8% in June – the lowest since October 2021 and below economist estimates of 5%. On a month-on-month basis, headline and core inflation both came in at 0.2%, which was lower than the 0.3% predicted by economists. Overall, the figures underscore the progress made by the Fed in reducing price pressures after inflation peaked a year ago, aided by more than a year of interest-rate hikes and lower demand.

Stocks

The S&P 500 faces more difficulties ahead due to profit warnings and higher interest rate fears, according to the latest Markets Live Pulse survey conducted by Bloomberg. Over half of the 346 respondents predict that the upcoming earnings season, usually a positive period for equities, will negatively impact stocks. The survey also reveals declining optimism for a soft economic landing amidst persistent inflation that keeps central banks leaning toward tighter monetary policy.

Tech stocks, which make up a huge chunk of the S&P 500, will be especially in focus due to their soaring valuations. While the tech rally was boosted by the hype around AI, over 70% of survey participants say the impact of AI on tech earnings is overblown. That leaves companies leading the AI push, including Microsoft and Nvidia, more vulnerable to stock declines should their earnings fail to meet investors' lofty expectations.

Speaking of Microsoft, Morgan Stanley predicts that gains driven by AI could elevate the firm to join Apple in the exclusive group of stocks with a market capitalization exceeding $3 trillion. The investment bank recently raised its price target for Microsoft from $335 to $415, implying a valuation of $3.1 trillion. The firm is Morgan Stanley’s top pick among large-cap software companies, predicting that it’s best positioned in the sector to benefit from the growth of AI. That bullish price target comes despite a strong year-to-date rally in Microsoft’s shares. According to Morgan Stanley, the software-maker’s valuation is still reasonable based on the PEG ratio (the forward P/E multiple divided by the expected percentage growth in earnings), which remains in-line with historical averages despite the huge growth potential offered by AI.

In fact, so strong is the market frenzy around AI that the six biggest tech firms in the US – Microsoft, Apple, Alphabet, Nvidia, Amazon, and Tesla – have seen their shares advance 62% on average year-to-date, almost three times as much as the average stock in the Nasdaq 100. That’s left the six stocks comprising more than 50% of the index – way too high for Nasdaq’s liking. That’s why the firm announced last week that its flagship stock market index, the Nasdaq 100, will undergo a “special rebalance” – the first of its kind – to address the benchmark’s overconcentration. The rebalance, which goes into effect on Monday the 24th of July, will not result in the removal or addition of any securities – only a rejigging of their underlying weights. The collective weight of the six mega-cap tech stocks is expected to be cut from 50% to 40% – a reduction of a fifth.

That means portfolios benchmarked to the Nasdaq 100 and funds that track the index, including the $200 billion Invesco QQQ ETF, will be forced to sell the names that are having their weights reduced and buy others that will be increasing. Incidentally, all six of the mega-cap tech stocks fell last Monday, with shares of Alphabet and Amazon dropping more than 2%. And while the overall Nasdaq 100 was flat, an equal-weighted version that strips out market cap bias climbed 1.8%. It’s a drastic reversal from the previous six months, when the equal-weighted index trailed by 18 percentage points.

This week

• Monday: China GDP (Q2), China retail sales (June).
• Tuesday: US retail sales (June), Canada inflation (June). Earnings: Bank of America, Morgan Stanley.
• Wednesday: UK inflation (June), US housing starts (June). Earnings: Goldman Sachs, IBM, Netflix, Tesla.
• Thursday: Japan trade balance (June), China 1-year loan prime rate announcement, US existing home sales (June). Earnings: Blackstone, Johnson & Johnson, Philip Morris International.
• Friday: Japan inflation (June), Canada retail sales (June), UK retail sales (June). Earnings: American Express.