Trying To Break The (Wage-Price) Spiral

Last week saw more data releases confirming that China’s economic recovery is losing steam. First, Chinese banks extended the fewest monthly loans in July since 2009, signaling further weakening demand. Second, growth in consumer spending, industrial production, and fixed-asset investment all slid across the board in July. That might explain why the Chinese central bank unexpectedly cut interest rates last week in a move that could lead to renewed pressure on the yuan, which is already hovering near a 16-year low. Elsewhere in Asia, new data out last week showed Japan’s economy expanded at a much faster rate than forecast thanks to booming exports. Over in the UK, wages grew more than expected and at a record annual pace in the three months to June. UK inflation, meanwhile, dropped sharply in July, but core price gains stayed put. Finally, equity positioning among volatility-controlled funds is hovering near a ten-year high, which could spell bad news for the market. Find out more in this week’s review.

Macro

China slid into deflation in July, highlighting the disappointing state of domestic demand in the world’s second-biggest economy eight months after it abandoned strict zero-Covid policies. Adding to the country’s woes, new data revealed that Chinese banks extended the fewest monthly loans in July since 2009, signaling further weakening demand and heightening the risk of prolonged deflationary pressure in the country’s economy. New loans reached 345.9 billion yuan in July – less than half the 780 billion yuan economists had forecast.

The much lower-than-expected credit growth last month shows that the rate cut in June by the People’s Bank of China (PBoC) wasn’t enough to bolster sentiment in the economy. The central bank has been deliberately proceeding with caution, held back by factors like a declining yuan and rising financial stability risks due to elevated debt levels in the economy. However, it decided to throw caution to the wind last week, unexpectedly cutting a key interest rate by the biggest margin since 2020. The PBoC reduced the rate on its one-year medium-term lending facility by 15 basis points to 2.5% last Tuesday, marking the second reduction since June. Of the 15 analysts surveyed by Bloomberg, all but one anticipated the rate would remain unchanged. A short-term policy rate (the seven-day reverse repo rate) was also lowered, but by 10 basis points.

The surprise move coincided with the release of disappointing economic activity data for July, which showed growth in consumer spending, industrial production, and fixed-asset investment sliding across the board, while unemployment increased. Industrial production increased 3.7% in July from a year earlier – a slowdown from June’s 4.4% and lower than the 4.3% predicted by economists. Year-over-year growth in retail sales slowed to 2.5% in July from 3.1% the month before, coming in far below economists’ forecasts of 4%. That prompted several banks to downgrade their annual growth estimates for China. JPMorgan, for example, lowered its full-year forecast for 2023 to 4.8%, while Barclays cut its growth estimate to 4.5% – both below the government’s official target of around 5% expansion.

The PBoC’s unexpected decision to cut two of its key policy rates is also expected to add more pressure on the yuan, which is already hovering near a 16-year low amid a waning economic growth outlook. As the Fed continues to raise interest rates to curb inflation, the yield differential between 10-year US and Chinese government bonds widened to over 160 basis points last week. That’s the largest gap since 2007, prompting investors to shift capital from China to the US, further exacerbating the yuan's decline and deterring much-needed foreign investment into the country.

Elsewhere in Asia, new data out last week showed Japan’s economy expanded at a much faster rate than forecast, with a massive boost in exports more than offsetting weak results for both business investment and private consumption. Japan’s GDP grew at an annualized pace of 6% in the second quarter from the one before – more than double the 2.9% rate forecast by economists and marking the strongest growth since late 2020. Net exports, led by booming car sales, resurgent inbound tourism, and a weaker yen, contributed 1.8 percentage points to the expansion versus economist estimates of 0.9 points.

But while the weak Japanese currency, which remains close to multi-decade lows relative to the US dollar, has been a boon to the nation’s exporters, it’s hitting domestic consumption by contributing to higher import prices. Case in point: private consumption, which makes up more than half of the Japanese economy, fell 0.5% quarter on quarter. That softness will probably dampen market speculation that the Bank of Japan will use the strong GDP headline figure as a reason to consider moving away from its massive monetary stimulus measures.

Over in the UK, new data out last Tuesday showed wages in Britain grew more than expected and at a record annual pace in the three months to June. Average pay excluding bonuses rose 7.8% from a year ago, topping economist forecasts of 7.4% and marking the highest reading since records began in 2001. That will fuel the Bank of England’s concerns that it hasn’t yet broken the wage-price spiral feeding inflation across the economy. 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.

Speaking of inflation in the UK, new data released a day later showed that consumer prices in Britain were 6.8% higher in July than they were a year ago – slightly above the 6.7% rate expected by economists but a notable decrease from June’s 7.9% pace, mainly thanks to lower energy prices in July. Still, it marked the fifth time in the past six months that the figures exceeded expectations, with inflation more than triple the BoE’s 2% target. What’s more, core inflation, which excludes volatile food and energy prices, held steady at 6.9% in July instead of ticking down as economists had expected.

In even worse news for the BoE, services inflation, which officials see as the best indicator of underlying price pressures, accelerated by 0.2 percentage points to 7.4% in July, matching highs touched in May and in 1992. All in all, the data showed that the central bank’s job is nowhere near done, and could explain why traders are now betting that the BoE will raise rates by another 75 basis points to 6% by March.

Stocks

Risk-parity funds, also known as volatility-controlled or volatility-weighted funds, account for a significant share of trading volumes. They use rules-based strategies to allocate their portfolios according to risk, piling up on assets when they rally during periods of low volatility and offloading them when trading gets choppy – irrespective of market direction. Today, equity positioning among these funds is hovering near a ten-year high on the back of rising stock prices and falling volatility. But that elevated exposure could lead to lots of forced selling should volatility spike.

For example, according to investment bank Nomura, it could take just a 1% move in the S&P 500 – up or down – every day for a week to trigger a huge bout of selling among volatility-controlled funds, potentially halting the rally in US stocks. The last time the S&P 500 fluctuated by more than 1% a day for a whole week was at the start of February, which incidentally was the index’s only negative month so far this year.

What’s more, the asymmetry in potential selling versus further buying from these funds is huge, according to Nomura. A 1% daily fluctuation in the S&P 500 over a week, for example, could result in approximately $28.8 billion in stock sales. In contrast, a calm, sideways market would only generate about $2.3 billion in additional purchases.

A forced wave of selling that reverses the rally in US stocks could also trigger subsequent sales by another set of funds: commodity trading advisors (CTAs). These hedge funds buy and short futures to ride trends across different markets, and they’ve increased their exposure to stocks to the highest level since before the pandemic, according to Deutsche Bank. For CTAs, both volatility and trend signals are crucial. So should volatility spike and US stocks start heading south, they’ll also be forced to dump their holdings, exacerbating the selloff.

This week

• Monday: Earnings: Zoom.
• Tuesday: US existing home sales (July). Earnings: Baidu, Medtronic.
• Wednesday: US new home sales (July), Japan, eurozone, UK, and US PMIs (August). Earnings: Nvidia, Snowflake.
• Thursday: US durable goods orders (July). Earnings: Intuit.
• Friday: Nothing major.