Cooling Inflation

Hello Traders, we hope you’re having a nice weekend. Here are some of the biggest stories this week:

• US inflation was slightly cooler than expected in December.
• Trump is considering a softer approach to planned tariff hikes.
• UK inflation unexpectedly slowed last month.
• Britain’s economic growth in November missed forecasts.
• China’s trade surplus hit a record in 2024.
• The world’s second-biggest economy met its 2024 growth target.

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

US

A blowout jobs report earlier this month had fueled concerns that the US labor market isn’t cooling enough to bring down the country’s stubbornly high inflation. That’s raised the possibility that the Fed may need to take a long pause from cutting interest rates – a prospect that’s been rattling markets recently. Fortunately, investors got the tiniest bit of good news on Wednesday, after the latest inflation report came in slightly cooler than expected. Consumer prices in the US increased by 2.9% in December from a year ago. That marked the third consecutive month of rising inflation, sure, but it was in-line with economist expectations. However, core inflation, which strips out volatile food and energy items to give a better idea of underlying price pressures, fell to 3.2%, defying forecasts for a flat reading.

US stocks jumped after the report, while Treasury yields and the greenback slumped. That came as traders adjusted their expectations for when the Fed will next cut interest rates, now betting the central bank will lower them by July – compared with September before the data was published. But if all these outsized market moves to an inflation report that was only slightly better than expected suggest anything, it’s that many traders are on edge and had been bracing for a much worse reading.

Now, while the slowdown in core inflation is good news for the Fed and American households, investors are still contending with a big elephant in the room: Donald Trump’s tariff plans. The former president, who’s set to return to the White House on Monday, has proposed a minimum 10% levy on all US imports and a 60% tax on all goods coming from China. According to calculations from Barclays, the measures would amount to an import-weighted average tariff of 17% – a level not seen since 1935. 

Needless to say, an average tariff of 17% would lead to higher costs for American consumers and drive up inflation. And fears of another surge in consumer prices have unsettled markets in recent weeks, causing both stocks and bonds to fall at the same time. So now members of the incoming US administration are reportedly discussing a different idea: slowly ramping up tariffs month by month – a gradual approach aimed at boosting negotiating leverage while helping avoid a spike in inflation.

But whether tariffs are applied gradually or all at once, one thing seems certain: the US’s trading partners are increasingly willing to respond. Canada’s US ambassador, for example, said this week that Trump’s 25% tariff threat on Canadian products would lead to a “tit for tat” retaliation from the country. Other nations, from Mexico to China, have also threatened to respond in some way. But all those retaliatory actions could risk spiraling into an all-out trade war that upsets the global economy.

UK

UK inflation unexpectedly cooled for the first time in three months in December, prompting traders to increase bets on Bank of England interest rate cuts this year and calming market concerns about the country’s soaring borrowing costs. Consumer prices increased by 2.5% last month from a year ago, down from November’s 2.6% pace and defying economist expectations for an unchanged reading. Meanwhile, core inflation, which strips out volatile food and energy items to give a better idea of underlying price pressures, dropped from 3.5% to 3.2%. Adding to the good news, services inflation, a measure closely watched by the BoE for signs of domestic price pressures linked to the labor market, eased more than forecast from 5% to 4.4% – the lowest reading since March 2022.

Data out a day later showed Britain’s economy narrowly returned to growth in November but fell short of analyst expectations. Economic output increased by 0.1% following a 0.1% contraction in both September and October. Still, that was below forecasts for a 0.2% expansion, and did little to ease concerns that the country is teetering on the edge of stagflation – where sluggish growth is accompanied by persistent price pressures. Britain’s economy, for example, was flat in the third quarter, and will stagnate for a second straight quarter unless GDP grows by more than 0.07% in December. However, combined with this week’s report that showed inflation unexpectedly cooling, the weaker-than-expected growth figures could help pave the way for faster rate cuts by the BoE. That, in turn, could provide a much-needed boost to the economy this year.

China

New data this week showed China’s trade surplus – the difference between its exports and imports of goods – hit an all-time high of $992 billion last year, representing a 21% increase from 2023. The surge was driven by record exports, coupled with weak imports weighed down by sluggish domestic consumption and declining commodity prices. Notably, last year’s record exports came despite falling prices, highlighting a huge rise in export volumes. And while the US and Europe have been the most vocal about the surge, the truth is that the trade imbalance extends beyond just those two regions. Case in point: China now exports more goods to almost 170 countries and economies than it buys from them – the most since 2021.

China’s export surge last year was no accident. See, consumer spending in the country has been sluggish, weighed down by low confidence and a persistent real estate crisis that has eroded household wealth. To help offset the slump in domestic demand, authorities have encouraged more output from the country’s manufacturing sector, leading to stronger exports – and a wave of accusations about overproduction and dumping from China’s trading partners.

Unsurprisingly, those trading partners are now threatening hefty tariffs on Chinese goods, which would not spell good news for the world’s second-biggest economy. Trump’s 60% tariff threat, for example, could cause Chinese economic growth to suffer a hit of as much as two percentage points, according to Standard Chartered and Macquarie.

Speaking of which, new data this week showed China’s economy grew by a more-than-expected 5.4% last quarter from a year ago, boosted by the broad package of stimulus measures unleashed by authorities in September. The figures meant that the world’s second-biggest economy expanded by 5% in 2024, in-line with the government’s official target. While the annual figure was slightly better than forecasts of 4.9%, it trailed 2023’s growth of 5.2% and was the lowest since 1990 (excluding years distorted by the coronavirus pandemic).

Next week

• Monday: China one- and five-year loan prime rate announcements.
• Tuesday: UK labor market report (November), eurozone economic sentiment (January). Earnings: Netflix, 3M.
• Wednesday: Earnings: Procter & Gamble, Johnson & Johnson, Abbott Laboratories, GE Vernova.
• Thursday: Japan trade balance (December), eurozone consumer confidence (January). Earnings: GE Aerospace, Intuitive Surgical.
• Friday: Japan inflation (December), Bank of Japan interest rate announcement, global PMIs (January), US consumer sentiment (January). Earnings: American Express, Verizon Communications.