Stubborn Inflation

Here are some of the biggest stories from last week:

• US inflation accelerated by more than expected in March.
• Consumer prices in China barely increased last month.
• The European Central Bank kept interest rates unchanged.
• Global stock market concentration reached its highest level in decades.
• Investors have piled on the most bets for the yen to fall in 17 years.
• The price of gold hit a new record high.

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

Macro

Investors got another bad surprise this week after the latest US inflation report showed the pace of price gains accelerating by more than forecast in March. Consumer prices rose by a more-than-expected 3.5% last month from a year ago, up from 3.2% in February, partly due to higher energy costs. But even core inflation, which strips out volatile food and energy items to give a better idea of underlying price pressures, stayed flat at 3.8%, defying expectations for a small slowdown. On a month-over-month basis, headline and core inflation both exceeded forecasts, with both coming in at 0.4% (unchanged from February).

The report adds to evidence that progress on taming inflation may be stalling, partly due to a strong labor market that’s powering consumer spending despite the Fed keeping interest rates at a two-decade high. That explains why the central bank is wary of easing policy too soon, saying that it wants to see price pressures sustainably cooling before lowering borrowing costs. Following the inflation report, traders pushed the first expected rate cut out to September. They now anticipate only two reductions in 2024 – down from an earlier forecast of six at the start of the year.

Over in China, the world’s second-biggest economy is dealing with the opposite problem, with inflation still virtually nonexistent due to persistently weak consumer demand. New data this week showed consumer prices rose by 0.1% in March from a year ago – less than the 0.4% gain forecast by economists. It also marked a big drop from February’s 0.7% pace, when inflation had climbed above zero for the first time in six months during the Lunar New Year holiday. What’s more, producer prices, which reflect what factories charge wholesalers for products, fell for an 18th straight month, dropping by a bigger-than-expected 2.8% in March. 

With inflation surprising on the upside in the US and on the downside in China, the monetary policy stances in these two countries may continue to diverge. Put differently, the big interest-rate gap between the world’s two biggest economies will likely persist, which could add downward pressure on the yuan. The disparity will also make it harder for China to trim its own rates – even though it needs to – due to concern about further weakening of the currency. Before China’s inflation numbers came out, the central bank signaled continued support for the yuan after the currency weakened overnight in response to the US inflation surprise. The central bank set its daily yuan reference rate at 7.0968 per dollar on Thursday, exceeding forecasts by the most on record.

Finally, over in Europe, the ECB held interest rates steady for a fifth straight meeting while sending its clearest signal yet that cooling inflation will soon allow it to begin cutting borrowing costs. The deposit rate was left at a record-high 4%, as predicted by the vast majority of economists. But the central bank said that it would be appropriate to lower rates if underlying price pressures and the impact of previous rate hikes increased its confidence that inflation was closing in on its 2% target in a sustained manner. A rate cut would come as a relief for the region’s economy, which has barely registered any growth for more than a year. 

Stocks

Investors in global index funds and ETFs might not be getting the diversification they’re looking for, with stock market concentration rising to its highest level in decades this month. The 10 biggest stocks in the MSCI All Country World Index, which is made up of 23 developed and 24 emerging markets, now account for 19.5% of the widely followed benchmark. This is up from less than 9% as recently as 2016 and well above the dotcom era peak of 16.2% in March 2000, according to MSCI data stretching back to 1994. That matters, because today’s more concentrated stock market is more prone to substantial falls in value – especially considering that many of the biggest stocks are viewed as AI plays, which could spell trouble for investors if the technology doesn’t live up to its huge hype.

In the MSCI World Index, which is made up of developed markets only, the top 10 stocks account for 21.7% of the benchmark. What’s more, the 10 heavyweights are all American companies, which has helped drive the US’s weight in the index to almost 71%. Such a high concentration in the country leaves investors vulnerable to the macroeconomic conditions and market sentiments specific to the US. In other words, it’s not quite the diversification you might expect from a “global” stock index…

Currencies

It would have been reasonable to assume that the Bank of Japan's move to scrap the world's only remaining negative interest rate last month would lead to a stronger yen. Higher interest rates, after all, make the currency more attractive to international savers and investors. However, the real world doesn't always align with expectations, and the yen has fallen against the US dollar since the BoJ’s first rate hike in nearly two decades, leaving the currency near a 34-year low.

Traders expect that trend to continue, amassing the most bets for the yen to fall in 17 years despite repeated warnings from Japanese officials that they might intervene to halt the currency’s slide. The net number of yen futures held short by hedge funds and asset managers rose to 148,388 contracts at the start of April – the highest since January 2007.

The yen’s weakness and traders’ growing bets against it come down to two main things. First, the BoJ’s indication last month that financial conditions will remain accommodative clearly showed that its first rate hike in 17 years isn’t the start of an aggressive monetary tightening cycle of the sort seen recently in the US and Europe. Second, a surprisingly strong US economy has driven investors to recently dial back their bets on rate cuts by the Fed. So despite Japan bringing interest rates up from their sub-zero spot, those rates still look squat compared to the US and will probably stay that way for a while.

But all those bets against the yen could prime the currency for a perfect short squeeze if the BoJ decides to strongly intervene, forcing traders to rush to cover their shorts by purchasing the yen. Should that happen, corporate Japan will also feel the pinch too. The country’s biggest exporters and firms with a big global presence are benefiting from the weakest yen levels in decades – a currency factor that inflates their overseas earnings when converted into yen. But if the currency starts to strengthen, those earnings tailwinds will flip into reverse, potentially halting the recent rally in Japanese stocks.

Commodities

Investors seem to have caught the gold bug recently, with strong buying activity pushing the precious metal to continue its record-breaking streak this week, reaching a new all-time high of $2,400 an ounce. The latest surge is driven by a few factors. First, increased demand for safe-haven assets amid rising geopolitical risks in the Middle East and Ukraine. Second, investors are buying gold as a hedge against inflation after the latest US report showed the pace of price gains accelerating by more than expected last month. Third, central banks are snapping up the precious metal at breakneck pace in a bid to diversify their reserves and reduce their reliance on the US dollar. Case in point: the People’s Bank of China purchased gold for its reserves for a 17th straight month in March, despite higher prices.

Next week

• Monday: US retail sales (March), eurozone industrial production (February). Earnings: Goldman Sachs.
• Tuesday: China industrial production and retail sales (March), China GDP (Q1), UK labor market report (March), US industrial production (March). Earnings: Bank of America, Johnson & Johnson, Morgan Stanley, UnitedHealth Group.
• Wednesday: Japan trade balance (March), UK inflation (March).
• Thursday: US existing home sales (March). Earnings: Blackstone, TSMC, Netflix.
• Friday: Japan inflation (March), UK retail sales (March). Earnings: American Express, Procter & Gamble.