China’s Falling Behind

Here are some of the biggest stories from last week:

• In a widely expected move, the Fed kept interest rates unchanged this week.
• The US Treasury announced its latest borrowing plans.
• The eurozone economy unexpectedly avoided a recession in the second half of 2023.
• Inflation in the bloc eased slightly in January, but services inflation stayed elevated.
• The Bank of England kept rates unchanged but opened the door to cuts later this year.
• China is falling further behind the US in the race for the world’s biggest economy.

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

US

At the US central bank’s latest meeting this week, Fed members voted unanimously to leave the federal funds rate unchanged for a fourth straight time at a 23-year high of 5.25-5.5%. The move was widely expected by traders, who have been more focused in recent weeks on when the central bank would begin making the 75 basis points worth of cuts its officials had predicted for this year. Market odds for a rate reduction in March, which had risen above 50% in recent months amid falling inflation, dropped to close to one-in-three after Fed chair Powell moved to cool speculation that the bank would cut that early. The US economy, after all, is still going strong, and Powell said that the bank needs greater confidence that inflation was sustainably lower before easing policy.

You might be forgiven for thinking that the Fed's interest rate decision was the headline act for bond market investors this week. But there was another key event that might have slipped past your radar: the Treasury’s announcement on its borrowing plans.

Every quarter, the Treasury announces how much funding it needs for the upcoming six months. And because of the enormous debts being accumulated by the US government, these announcements have now become market-moving events. More borrowing means more government bonds that will flow into the market. And the more bonds issued, the lower their prices and the higher their yields. For this quarter, the Treasury dropped its estimated borrowing by some $56 billion, driven by higher net inflows and having more cash on hand at the start of the quarter than expected.

Mind you, the remaining $760 billion in predicted funding is still among the most ever announced in any quarter. That’s because the government’s budget deficit – the difference between what it makes in taxes and spends – is only widening, with everything from tax cuts to mounting defense costs to economic stimulus initiatives to blame. While the Treasury has been selling bonds to plug the gap, that move will only add to the US’s eye-wateringly huge debt pile. That, at a time when high interest rates are ramping up payments on bonds and worsening the budget deficit. And so a vicious cycle starts: more bonds are sold, more interest is due on them, the worse the deficit gets, and repeat.

Europe

The eurozone economy flatlined in the last three months of 2023, registering 0% growth from the ones before, and narrowly dodging a technical recession by the slimmest of margins following a 0.1% decline between July and September. See, investors had expected another drop of that size last quarter, mainly driven by economy-busting high interest rates. However, strong growth in Italy and Spain helped offset declining German output and a stalled French economy. Germany, usually the bloc’s powerhouse, saw its economy shrink by 0.3% last quarter, bogged down by falling investment in construction, machinery, and equipment. On the flip side, Spain’s economy accelerated faster than expected, with quarterly growth of 0.6% – its strongest expansion of the year, thanks to rising domestic demand.

The bloc got some more good news, with new data showing the pace of consumer price gains easing slightly last month. Following a 0.5 percentage point climb to 2.9% in December, primarily due to the wind-down of energy price support measures, inflation decelerated to 2.8% in January – in line with economist expectations. However, it wasn’t all sunshine and rainbows: core inflation, which strips out volatile energy and food prices, fell slightly to 3.3%, but that was higher than the 3.2% economists were hoping for.

Finally, services inflation, which is closely watched by policymakers due to its close link with domestic wages, held steady at 4%. The European Central Bank has said that it wants to see signs of cooling wage growth before lowering borrowing costs, and so the elevated pace of price gains for labor-intensive services could be a sign that the labor market is still running hot. That could encourage the central bank to adopt a cautious approach, which is not what traders are currently betting on: the market is pricing in almost six quarter-point rate cuts this year, with the first one expected to come by April.

UK

In a widely expected move, the Bank of England held borrowing costs at 5.25% for the fourth consecutive meeting, but opened the door to rate cuts later this year. That comes after the central bank said it sees inflation dipping to its 2% target in the second quarter, thanks to tumbling energy prices. However, inflation is then expected to bounce up to almost 3% as the impact of cheaper energy fades and underlying price pressures in services and wages persist, suggesting the BoE will not cut rates as aggressively as some traders are betting on. On the flip side, cooling inflation and lower interest rates are expected to buoy the economy, with the central bank expecting an expansion of 0.25% this year, up from an earlier prediction of near zero. For 2025, the economy could show 0.75% growth, also stronger than previously forecast.

China

Not too long ago, China was expected to overtake the US as the world’s biggest economy from the start of the next decade. But that goal is starting to increasingly look like a pipe dream, especially after the US widened its lead over China last year.

The US economy grew by 6.3% in nominal terms – that is, unadjusted for inflation – in 2023, outpacing China’s 4.6% gain. Consequently, the size of China's economy relative to the US decreased to 65% by the end of last year, down from its peak of 75% at the end of 2021. While some of that outperformance can be attributed to the elevated pace of price gains in the US, the figures highlight a significant underlying trend: the US economy is emerging from the pandemic in a stronger position compared to China. This outperformance is reflected in the respective countries’ stock markets. While US shares are at all-time highs, Chinese equities are currently facing a bear market rout exceeding $6 trillion.

Things weren’t expected to be this way. Many had predicted that the US economy would slide into recession last year due to the Fed’s aggressive interest rate hikes. Instead, lower inflation and a hot job market encouraged Americans to keep spending, shielding the economy from a downturn. China, on the other hand, was expected to experience a strong rebound after the government removed its strict zero-Covid restrictions. But the country has since been plagued by a whole host of issues, including its worst streak of deflation in some 25 years, an ongoing debt crisis in the property sector, fading consumer confidence, rising joblessness among young people, and a shrinking (and fast-aging) population. What’s more, exports – once a critical pillar of growth – declined in 2023 for the first time in seven years.

All those factors have led China to downshift to a slower growth path sooner than many economists had anticipated, with many of them no longer expecting the country to overtake the US as the world’s biggest economy in the near future. Bloomberg Economics, for example, forecasts that it will now take until the mid-2040s for China’s GDP to exceed the US’s. Even then, the lead will be marginal and short-lived.

Next week

• Monday: China PMIs (January). Earnings: McDonald’s, Caterpillar, Palantir.
• Tuesday: Japan household spending (December), eurozone retail sales (December). Earnings: Eli Lilly, Amgen, Spotify, Ford, Gilead Sciences.
• Wednesday: US trade balance (December). Earnings: Alibaba, ARM, PayPal, Disney, Uber.
• Thursday: China loan growth (January), China inflation (January). Earnings: Philip Morris.
• Friday: Earnings: PepsiCo.