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Dot Plot Shock
December 21
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Hello Traders, we hope you’re having a nice weekend. Here are some of the biggest stories this week:
Dig deeper into these stories in this week’s review.
While much of the world is still battling the final remnants of high inflation, China is grappling with a very different problem: deflation. See, a three-year crisis in the property sector has dented household wealth and buying confidence, causing people to spend less. This drop in aggregate demand has left consumer prices stagnant since early 2023. And new data this week showed annual inflation unexpectedly declined to a five-month low of 0.2% in November, despite a huge new stimulus package aimed at getting people spending again. On a month-over-month basis, consumer prices dropped by 0.6% from October to November. Finally, producer prices, which reflect what factories charge wholesalers for products, fell for the 26th consecutive month, declining by 2.5% in November from a year ago.
Now, November’s slight 0.2% rise in consumer prices doesn’t signal that China's economy is out of the woods just yet. After all, there’s a broad measure of prices that shows that the world’s second-biggest economy is still firmly in the deflation zone. That’s the “GDP deflator”, which offers a more comprehensive view of inflation than consumer prices alone because it takes into account price changes for all goods and services produced within an economy. So here’s the bad news: the metric shows there’s been six consecutive quarters of deflation in China – the longest stretch since 1999.
That’s sure to worry policymakers, since prolonged deflation can lead to a downward spiral of economic activity. See, anticipating further price drops, consumers might delay purchases, dampening already weak consumption. Businesses, in turn, might lower production and investment because of uncertain demand. What’s more, falling prices lead to lower corporate revenues, potentially hitting wages and profits. Finally, during times of deflation, prices and wages fall, but the value of debt doesn’t, which adds to the burden of repayments and raises the risk of defaults.
So, in a bid to boost the economy and avoid a negative spiral of falling prices and economic activity, Chinese authorities announced this week that they’re changing their stance on monetary policy from “prudent” to “moderately loose”. The last time the country adopted a moderately loose monetary policy stance was from late 2008 to late 2010, as part of a massive stimulus package to support the economy following the Global Financial Crisis. So the change of stance on Monday was taken by investors as a sign that the leadership was finally taking China’s economic problems more seriously.
According to new data by EPFR this week, investors have poured nearly $140 billion into US equity funds since last month’s election, betting that Trump’s incoming administration will deliver sweeping tax cuts and reforms that benefit corporate America. The rush of buying made November the busiest month for inflows on records stretching back to 2000, and has helped drive the S&P 500 to a series of all-time highs. Smaller companies, which are seen as more sensitive to fluctuations in the US economy, have performed even better since the election, with the Russell 2000 recently hitting a record high for the first time in three years. However, this wave of optimism also indicates that traders are largely brushing off concerns that some of Trump’s policy proposals, such as widespread increases in tariffs, could drive up inflation and threaten the Fed’s plans to continue cutting interest rates next year.
Looking at the bigger picture, November was the strongest month for inflows into equity funds globally since the peak of the meme stock mania in early 2021. However, the strength in the US masked weaknesses elsewhere, with investors pulling money from regions seen as more vulnerable to a potential trade war. Funds that invest in emerging markets have suffered net outflows of $8 billion since the election, including around $4 billion withdrawn from China-focused funds. Those that invest in western Europe have lost around $14 billion, while Japan-focused funds have shed around $6 billion, according to EPFR.
On the macro front, new data this week showed consumer prices in the US increased by 2.7% last month from a year ago – in line with economist expectations but higher than October’s rate of 2.6%. Core inflation, which strips out volatile food and energy items to give a better idea of underlying price pressures, remained unchanged at 3.3%. On a month-over-month basis, both headline and core consumer prices increased by 0.3%, also aligning with forecasts.
Overall, the figures are unlikely to change the Fed’s short-term plans for interest rate cuts. The central bank is widely expected to make its third consecutive reduction to borrowing costs next week. But the trajectory next year is less certain, as the Fed wrestles with its dual mandate of keeping inflation close to 2% and maintaining a healthy labor market. What’s more, some of the incoming US administration’s policy proposals, such as widespread increases in tariffs, could trigger another surge in inflation. But at least traders will get some clues on the Fed’s thinking on Wednesday when, alongside its latest decision, the central bank releases an updated “dot plot” – a closely watched forecast that shows where members see interest rates moving in the medium term.
Speaking of interest rates, the European Central Bank cut borrowing costs for the fourth time this year, taking its key deposit rate down by a quarter of a percentage point to 3%. The move came as the bank warned that the eurozone economy would grow by just 1.1% in 2025, down from its September estimate of 1.3%. It also slightly lowered its inflation forecast for next year to 2.4%. Looking ahead, traders expect the ECB to deliver five more quarter-point cuts by September, which would take the deposit rate down to 1.75%.
General Disclaimer
This content is for informational purposes only and does not constitute financial advice or a recommendation to buy or sell. Investments carry risks, including the potential loss of capital. Past performance is not indicative of future results. Before making investment decisions, consider your financial objectives or consult a qualified financial advisor.
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