US Inflation’s Accelerating

Here are some of the biggest stories from last week:

• Global food prices posted their biggest annual drop since 2015.
• Inflation in the US accelerated last month.
• The eurozone’s unemployment rate hit a record low.
• Economic confidence in the bloc improved for a third consecutive month.
• Chinese stocks are extremely cheap compared to bonds.
• Japanese stocks hit a fresh 34-year high.
• The SEC approved the first bitcoin spot ETFs.

Dig deeper into these stories in this week’s review.

Macro

Food has been a major driver of rising global inflation over the last couple of years, with blocked supply chains and the outbreak of war sending the prices of agricultural commodities skyrocketing. But in what will be welcome news for consumers and central banks, new data this week showed an index of food-commodity prices created by the United Nations’ Food and Agriculture Organization falling about 10% in 2023 – its biggest annual drop since 2015. Although the index tracks raw commodity costs rather than retail prices, the steep drop could indicate potential relief on the way for consumers, helping alleviate the cost-of-living crisis facing many countries across the world. But don’t expect it to happen immediately: while the UN’s index is now at the lowest level since February 2021, it often takes a while for lower wholesale costs to trickle down to supermarkets and consumers.

Speaking of inflation, the US got some bad news on that front last week, dampening hopes for an interest rate cut as early as March. Consumer prices rose by a more-than-expected 3.4% in December from a year ago – a marked acceleration from November’s 3.1% pace, as Americans paid more for housing and driving. Core inflation, which strips out volatile food and energy items to give a better idea of underlying price pressures, eased slightly to 3.9% in December from 4% the month before, although that was higher than the 3.8% economists were hoping for. On a month-over-month basis, headline inflation also accelerated to a higher-than-expected 0.3%, with shelter prices, which make up about a third of the overall CPI index, contributing to more than half of the advance. Core inflation matched forecasts to remain flat at 0.3% in December.

Elsewhere, despite concerns that the eurozone economy slipped into recession in the latter half of last year, unemployment in the bloc equaled its record low in November, with the jobless rate unexpectedly dropping to 6.4% from 6.5% the month before. The data highlights the reason behind the European Central Bank's decision to not consider reducing interest rates in the near future. See, despite the mild economic downturn, employers are facing challenges in finding staff, leading to increased wages and consequently posing upward risks for inflation. ECB policymakers don’t expect to reduce borrowing costs until at least the middle of the year – a later timeline than traders’ current expectations.

The falling jobless rate could explain why economic confidence in the eurozone improved for a third consecutive month in December. The eurozone sentiment indicator – an aggregate measure of business and consumer confidence published by the European Commission – rose to 96.4 last month, marking the highest level since May and surpassing the forecasts of all economists. The jump was driven by increases across all sub-indicators (industry, services, and consumer), though the reading remains below the long-term average of 100. Still, the data raised hopes that the region may be heading for a mild recovery after a combination of higher interest rates, sluggish growth in China, and the aftermath of the energy crisis took a toll on the bloc’s economy.

Stocks

A housing slump, rising geopolitical tensions, subdued consumer confidence, and lack of major stimulus by the government have left Chinese stocks extremely out of favor. But with the level of pessimism toward the country’s economy and markets as high as it is now, perhaps it pays to be a contrarian. And at least one indicator suggests grounds for optimism: the “risk premium” of Chinese stocks has reached a level that, historically, has been associated with fantastic returns over the next 12 months.

This risk premium measure, sometimes referred to as the “Fed model”, compares the stock market’s earnings yield to the yield on long-term government bonds. When stock valuations fall, their earnings yield – the inverse of their price-to-earnings (P/E) ratio – rises. Put differently, a high earnings yield means that the P/E is low and stock prices are cheap in relation to earnings. Similarly, the higher the yield on bonds, the cheaper they are. Now, look at the difference between the earnings yield and long-term government bond yields, and you've got a useful – albeit approximate – indicator of the relative attractiveness of stocks versus bonds.

Today, at around 8%, the earnings yield of the CSI 300 Index of Chinese stocks stands 5.7 percentage points higher than the yield on 10-year Chinese government bonds. Such a big gap has seldom been seen over the past two decades. Likewise, for the first time since at least 2005, the CSI 300’s dividend yield has surpassed the yield of long-term bonds. In essence, this all indicates that Chinese stocks are dirt cheap, and there’s no shortage of other measures to show that. The P/E ratio based on expected profits for Chinese companies, for example, currently sits below 10 – almost half the global average.

Now, what's notable about this Chinese version of the Fed model is its historical reliability in forecasting future stock returns. Over the past two decades, there have been five instances when the stock-bond yield gap exceeded 5.5 percentage points, including during the 2008 financial crisis and the 2020 pandemic. Following each of these periods, stocks always rose over the next 12 months, yielding an impressive average return of 57%. That said, cheap valuations have failed to be enough of a draw for Chinese stocks lately – a painful lesson learned last year. But for those brave enough to take a contrarian view, it’s at least reassuring to know that history is on their side.

Elsewhere in Asia, Japanese stocks continued their strong advance to hit a fresh 34-year high. The Nikkei 225 Index rose 6.6% this week to close at 35,577 – a level unseen since February 1990 during the nation’s bubble economy era. The jump suggests that investor optimism toward Japanese shares remains strong this year after the index rose by 28% in 2023 to mark its best performance in a decade. That surge was driven by solid company earnings, corporate governance reforms championed by the Tokyo Stock Exchange, the resurgence of inflation in Japan, and an extended period of weakness in the yen (boosting exporters’ earnings). 

Crypto

In a significant development eagerly anticipated by cryptocurrency enthusiasts, the SEC approved the first ETFs that directly invest in bitcoin on Wednesday. These funds, long sought by firms like BlackRock, Fidelity, Invesco, Grayscale, and WisdomTree, allow investors to access bitcoin by simply purchasing shares, similar to buying stock. Crypto buffs are betting that the whole new way to easily invest in bitcoin without directly owning the asset in a digital wallet will draw new retail and institutional investors to the coin, boosting its value. That’s why traders have been buying in anticipation of the US approval of the first spot ETFs, which helped send bitcoin’s price more than 150% higher last year. Following this trend, the launch of the near dozen ETFs saw a strong start, with about $4.6 billion of shares traded in a bustling first day on Thursday.

Next week

• Monday: Eurozone industrial production (November) and trade balance (November).
• Tuesday: UK labor market report (December). Earnings: Goldman Sachs, Morgan Stanley.
• Wednesday: China GDP (Q4), UK inflation (December), China industrial output and retail sales (December), US retail sales (December).
• Thursday: Minutes of the ECB’s latest meeting, US housing starts (December). Earnings: TSMC.
• Friday: Japan inflation (December), UK retail sales (December), US consumer sentiment (January), US existing home sales (December). Earnings: Schlumberger.