China: A Nation In Deflation

Chinese exports and imports both tumbled last month, intensifying concerns about the growth trajectory of the world's second-biggest economy. To add to investors’ worries, new data out last week also showed the country slid into deflation with consumer prices dropping by 0.3% in July. In contrast, a closely watched market measure of long-term inflation expectations in the eurozone hit a 13-year high last week. And in the US, inflation edged up slightly in July but by less than economists had expected. Elsewhere, the UK economy surprised investors with its strongest quarterly growth in more than a year. Finally, Moody’s Investors Service downgraded the credit ratings of 10 small and midsize American lenders last week, putting bank investors on edge. And adding to the gloom, bank investors overseas also faced a bad jolt last week after Italy’s government spooked markets with an unexpected 40% tax on lenders’ windfall profits. Find out more in this week’s review.

Macro

According to new data out last week, China’s exports and imports both fell more sharply than expected in July. In dollar terms, exports declined by 14.5% – the steepest fall since the outset of the pandemic in February 2020. Imports tumbled by 12.4% to mark the biggest decline since a wave of infections hit China in January, and was much bigger than the 5% drop forecast by economists.

China's exports played a significant role in supporting its economy during three years of global restrictions, but they’ve declined (on a year-on-year basis) in each of the past three months due to high global inflation and rising interest rates that have dampened demand for the country’s products. The steep fall in imports, meanwhile, highlights the disappointing state of domestic demand eight months after China abandoned its strict zero-Covid policies.

And just in case investors needed more evidence of the depressing state of domestic demand in China, new data out last week showed the country slid into deflation in July. Consumer prices in China dropped 0.3% last month from a year earlier, marking the first decline since February 2021. Producer prices, meanwhile, fell for a 10th consecutive month, contracting 4.4% in July from a year earlier. What’s more, it’s the first time since November 2020 that both measures fell in tandem, potentially pushing the People’s Bank of China towards further monetary stimulus, like cutting interest rates. Yet, factors like a declining yuan and elevated debt levels in the economy will likely make the central bank proceed with caution.

In contrast to China, the eurozone does have an inflation problem. A closely watched market measure of long-term inflation expectations in the eurozone just hit a 13-year high, adding another challenge for the European Central Bank (ECB). The so-called five-year, five-year forward inflation swap – a market-derived measure of expected average inflation over the five-year period that begins five years from today – hit 2.67% last week. That’s its highest level since 2010, and comes despite signs that the current burst of inflation has peaked as tighter monetary policy takes effect.

But while the five-year, five-year swap rate aims to reflect long-term inflation expectations beyond the current economic cycle, in practice it often moves in line with short-term price pressures and has been lifted by a recent rise in energy prices. It can also be distorted by heightened hedging activity, especially during the reduced trading volumes of August. Still, the fact that it has been rising steadily in the past six months is a potential headache for the ECB, which will struggle to justify an end to its interest-rate hikes if markets are betting on long-term inflation staying above the central bank’s 2% target.

This market sentiment would also mark a stark departure from recent history, when eurozone inflation was persistently below the ECB’s target in the decade after the 2008 financial crisis, fueling predictions of a Japan-style deflationary slump. But those predictions are a thing of the past: wealth management firm Lombard Odier, for example, estimates that eurozone inflation could average 1.5 percentage points higher in the decade leading up to 2032 compared to the prior decade, as rising energy and goods prices (exacerbated by the Russia-Ukraine conflict) lead to higher wage demands.

Over in America, the latest inflation report out last week showed the pace of price gains edged up slightly in July but by less than economists had expected. Consumer prices in the US were 3.2% higher last month from a year ago – a slight uptick from June’s 3% rate but slightly below economists’ forecasts of 3.3%. Core inflation, which strips out volatile food and energy components, decelerated from 4.8% in June to 4.7% last month, which was in line with economists’ estimates. While still elevated, the measure has slowed nearly every month since peaking at 6.6% in September. On a month-on-month basis, both headline and core inflation came in at 0.2%, also in line with forecasts. Overall, a decent report that will likely prompt the Fed to keep interest rates unchanged next month.

Finally, new data out last Friday showed the UK economy delivered its strongest quarterly performance in over a year. GDP in Britain rose by 0.2% in the second quarter from the one before, surpassing the Bank of England's forecast of a 0.1% expansion. This surge in growth, fueled by strong performances in manufacturing, construction, consumer spending, and business investment, will likely keep upward pressure on wages and prices, compelling the BoE to contemplate further rate hikes. Despite the positive numbers, the UK is the only G7 country yet to fully bounce back from the pandemic, with quarterly GDP 0.2% below its pre-Covid peak.

Stocks

Investors, already rattled by the downfall of three US regional lenders this year, are keenly monitoring the banking sector for any further signs of stress. After all, higher interest rates are forcing firms to shell out more for deposits and pushing up other funding costs. What's more, those higher rates are eroding the value of banks’ assets and complicating refinancing efforts for commercial real estate borrowers, especially as the demand for office space falls.

Taken altogether, lenders' balance sheets have deteriorated significantly, pushing Moody’s Investors Service to downgrade the credit ratings of 10 small and midsize American banks last week. The firm also said that it may downgrade major lenders including U.S. Bancorp, Bank of New York Mellon, State Street, and Truist Financial as part of a sweeping look at mounting pressures on the industry.

To highlight lenders' weakening balance sheets, consider a new analysis out last week that showed US banks suffered almost $19 billion of losses on soured loans in the second quarter – an increase of around 17% on the previous three months and 75% higher than the same period last year. This comes on the back of rising defaults among credit card and commercial real estate borrowers, especially as those with floating-rate loans face higher repayments after the Fed aggressively raised interest rates. But it could be just the start: during the second quarter, for example, US banks collectively put aside an additional $21.5 billion of provisions to cover future loan losses. That’s the most they’ve put aside since mid-2020, and marked the third-highest amount in a decade.

Adding to the gloom, bank investors overseas also faced a bad jolt last week after Italy’s government spooked markets with an unexpected 40% tax on banks’ windfall profits, wiping out around $10 billion from the market value of the country’s lenders last Tuesday. The levy will be applied to banks’ net interest incomes and will be used to finance tax cuts and mortgage support for first-time owners. Analysts at Cit had initially estimated that the new proposal, which must secure parliamentary approval within 60 days to take effect, will wipe around 19% from the sector’s earnings.

Here’s how it works: the threshold for imposing the 40% tax would be based on the difference between a bank’s net interest income in 2021 and the figure for 2022 or 2023, whichever is bigger. Banks would pay the tax once their net interest income for the selected year exceeded 2021 by either 5% (if 2022 was used) or 10% (if 2023 was used). When the government first announced the levy, it said that it would not exceed 25% of a bank’s shareholders’ equity. However, a day later, the government said that the tax would not exceed 0.1% of a bank’s assets but without specifying whether global or just Italian assets would be used.

This week

• Monday: China foreign direct investment (July).
• Tuesday: Japan GDP (Q2), China retail sales and industrial production (July), UK labor market report (July), US retail sales (July). Earnings: Home Depot.
• Wednesday: UK inflation (July), minutes from the Fed’s latest meeting. Earnings: Cisco.
• Thursday: Japan trade balance (July). Earnings: Walmart, Applied Materials.
• Friday: Japan inflation (July), UK retail sales (July). Earnings: Xpeng.