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Issue 50: Data Allow Fed to Pause

September 18, 2023

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This Week’s Highlights

  • August inflation data make Fed pause a lock
    Though headline CPI continued a bounce back last month, core inflation remained on a downward trend, giving the Fed everything it needs to hold rates steady at this week’s FOMC. Policy beyond that will depend on the data, though we’re still betting against cuts until late 2024 at the soonest.
  • ECB hikes rates amidst likely stagflation
    The ECB hiked 25 bps last week, as its own economists predict stagnant growth through year end, plus stubborn inflation unlikely to fall below the bank’s target until late 2025. Though we expect easing by mid-2024, we remain pessimistic on European stocks in the near term.
  • G20 puts a spotlight on India
    India’s Narendra Modi hosted and China’s Xi Jinping skipped the recent G20 summit, naturally raising questions as to when India might surpass China within EM. While we don’t see India as a substitute for China in clients’ portfolios, we do believe its growth creates opportunity and merits attention.

The CIO’s Take:
As we approach this week’s September FOMC, much attention has been focused on US macroeconomic data and what it might tell us about the prospects for further rate hikes this year (bad news for stock and bond investors) versus the timing of an eventual pivot to easing (decidedly good news). What we got from last week’s August CPI report was that (a) inflation continues to soften—the core, quite gradually—such that it would now be a big surprise if the Fed does anything at its September meeting, and (b) given how high inflation remains, rate cuts don’t seem to be in the cards for at least another two or three quarters, at best. Given US stock valuations still seem a little high for such a timeline, and noting European stocks face downright precarious macro conditions in the months ahead, we allocate to markets around the world, but with a moderate overweight to emerging economies we think offer high-quality growth at a presently very reasonable price.

Data Allow Fed to Pause

August CPI higher on surging energy prices
As we expected, headline inflation continued its bounce back in August, according to CPI data from the US Bureau of Labor Statistics (BLS) released last Wednesday, with prices rising 0.6% month-over-month, corresponding to 3.7% year-over-year inflation. That was marginally hotter than the 3.6% rate economists were forecasting. Last month, those numbers came in at 0.2% and 3.2%, respectively (see plot below). What’s driving the U-turn in headline CPI? The culprit last month turned out to be energy prices, a risk we’ve highlighted in our commentary over the last few weeks, with a painful 10.6% surge in gas prices in August, and a 5.6% jump in the overall energy basket for the month. In fact, the effect of rising energy prices on inflation is large enough that it’s visible in year-over-year core CPI—a version of inflation stripping out the costs of food and energy—which actually declined from 4.7% in July to 4.3% in August.

Figure 1 Headline CPI Continues Bounce Back

Shelter costs should help going forward
While rising energy prices got the most attention from those reading deeper than headline CPI in last Wednesday’s report, some commentators noted a spike in shelter costs, which make up roughly one-third of the CPI basket, including a 7.8% year-over-year increase in primary residence rents and a 7.3% year-over-year climb in owners’ equivalent rent—a statistic meant to create an apples-to-apples comparison between rental costs and the costs of owning a property. Those numbers seem a little scary on the face of it, and this is indeed one of those components of inflation that can be particularly sticky. So should investors worry about the influence of housing costs and see August readings as a red flag? There’s reason to be more hopeful. The way BLS measures and reports on shelter costs leads their statistics to lag market conditions by around a year, and growth in rents has been slowing. Apartment List’s monthly National Rent Report, in fact, saw rents down -1.2% nationwide on a year-over-year basis in August: an unusually early start to seasonal winter declines. Moderating shelter costs could thus contribute to softening inflation in the months ahead, rather than work against decelerating prices.


How does all this impact next week’s FOMC?
At this point, despite some contrarians still pricing in a 3% probability the Fed will hike in September, we see a pause at next week’s meeting as a virtual certainty. Inflation’s core is clearly much more important in the minds of FOMC members than headline CPI, and it’s moving solidly in the right direction. Combine that with significant uncertainty over the “long and variable” lag in Fed policy’s impact—like the response of those shelter costs mentioned above to a rapid rise in interest rates—and the Fed’s option to pause again here to assess another month’s worth of data seems like a no-brainer.


What comes after a September pause?
In our view, there are now two major questions when it comes to the Fed. First, will the FOMC hold through its November and December meetings, as well, or put in another hike before year end? That will depend on where core inflation goes between now and the committee’s November gathering. As long as core inflation continues its current downward trend, the Fed will likely be content to persist in its ‘wait-and-see’ approach to further tightening. That’s especially true if bigger cracks emerge in the US economy, which would tell policy makers their approach is working. On the other hand, a robust economy would give Powell that much more flexibility, such that if data on growth remain strong and inflation prints hotter than expected in the next couple months, another hike before year end is definitely on the table. As the chart below shows, futures traders agree with our assessment.

Figure 2 Traders Still Pricing Plenty of Risk

A second key question is: When will the Fed begin easing? Here, unfortunately, we also see as very reasonable a pessimistic move in futures prices’ implying rate cuts will begin in mid-2024—in part because we still don’t rule out a recession by that point, which forces their hand. In the absence of a downturn in the US economy, we expect the Fed will err on the side of getting inflation back to its 2% target, which means stock market bulls could be waiting some time yet for the Fed to get dovish.

Eurozone Faces Stagflation

Inflation pushes the ECB to hike 25 bps
Last Thursday, the European Central Bank (ECB) definitely did not pause, instead choosing to raise its principal interest rate by 25bps. This latest increase, supported by a majority of the Governing Council, marks the ECB’s tenth consecutive rate hike as the bank grapples with inflation meaningfully hotter than what’s being experienced across the Atlantic. Indeed, ECB staff economists’ September forecast for Euro area CPI put average inflation at 5.6% in 2023, 3.2% in 2024, and 2.1% in 2025, with rising energy costs a major factor. Inflation is only expected to breach the bank’s 2% target in the final quarter of 2025. Even so, we expect this to be the last hike of the current tightening cycle. That prediction comes down to another difference between macro conditions in the Eurozone and the US: Whereas growth in the US is going strong, the Euro area is stagnating.


Tepid growth undercuts hawkish stance
As we’ve often highlighted, what makes the Fed’s position so enviable relative to that imposed on other central banks, and what gives Powell and his colleagues so much more flexibility in their approach, is that whereas US inflation seems to be coming down—not fast enough, in our view, by progress is progress—US growth is still quite impressive for this point in the tightening cycle. By contrast, ECB projections (see below) indicate the economy is currently quite slow, with a mere 0.1% growth expected in the last quarter of the year.
Figure 3 Eurozone Growth Stagnant This Year

This combination of minimal growth and high inflation—classic ‘stagflation’—leaves little margin for overtightening, with any misstep potentially leading to a painful recession. We aren’t the only ones to see this. Though ECB President Christine Lagarde tried with nuance to express a continuation of the bank’s stance, money markets’ forward bets are pricing in easing by next June, with nearly three 25-bps cuts throughout next year. In a rare occurrence just after a rate hike, the euro dipped 0.7% against the dollar, while 10-year German bond yields also declined. From an investor’s perspective, this challenging backdrop creates more risk than reward on the whole, in our view, though such precarious conditions can certainly lead to successful value investments in more selective, active strategies.

G20 Spotlight on India

World leaders talk policy in New Delhi
With emerging markets and developing economies projected by the IMF to account for over 80% of global growth next year, it’s fitting that just over a week ago Narendra Modi, Prime Minister of India, one of the world’s largest emerging markets, welcomed global leaders to his nation for this year’s Group of Twenty (G20) summit: an annual event bringing together representatives from the world’s twenty largest economies to discuss a range of global issues. India has not only featured prominently in the EM growth story, reaching 7.8% year-over-year GDP expansion in the second quarter, but the country has been remarkably efficient at translating its economic growth into stock market performance. Along those lines, just before the recent G20 meetings began, India’s stock market hit a record high market capitalization of US$3.8 trillion, making it the fifth largest country on the planet by the size of its equity market.


Foreign investors shift bets from China to India
Modi’s hosting of this year’s G20 also coincides with increasing interest on the part of foreign investors, as Bloomberg recently reported year-to-date net foreign flows into India topping US$16 billion, the greatest flood of capital into Indian stocks in three years. Part of India’s appeal to foreign institutions over the last couple years has been the hope that its stock market might serve as a substitute for investing in its neighbor, China, amidst concerns over the latter’s struggling economy and its geopolitical tensions with the US. China’s President, Xi Jinping, was himself conspicuously absent from the G20—the first time he has missed the event since assuming power in 2012—seemingly playing into a passing-the-torch narrative. In fact, while we do view India’s economic story to be a compelling one, we would not bet on the country soon replacing China.


India’s challenge in being the “next China”
For companies seeking supply chain diversification, India’s young workforce offers a source of competitive labor, to be sure, and we have seen manufacturers increasingly turning to India for production. That trend is starkly exemplified in the country’s rise from 1% of global iPhone production in 2021 to 7% in 2022. That said, we see India as having a long way to go before completing its transformation into a manufacturing powerhouse to rival China. At present, roughly 60% of the country’s workforce is not in high-tech manufacturing or IT services, but in the agricultural sector, versus less than 25% for China. Meanwhile, though the country ranks a league above everyone but China in terms of its number of STEM graduates, illiteracy in India is around 25%, compared with just 1% in China. Likewise, while India has made strides under Modi in infrastructure investment, relative to China’s system of strong top-down control, Indian policymakers must grapple with dozens of state governments and many more municipalities. Such business frictions have given India a reputation as a risky place for foreign companies to establish operations—a perception that will likely take time to change, even if sentiment toward China remains on a downtrend.


EM investments need not be ‘one or the other’
Rather than recommend against allocating to India, such statistics indicate to us just how much growth the country has ahead of it. On the other hand, digging deeper into the data, it’s clear to us that India does have a long way to go before reaching China’s level as a presence among developing economies—and we see China itself as many years behind other emerging markets like South Korea and Taiwan in terms of its financial and economic development. The fact is, emerging markets are a heterogeneous set much better suited to diversification across countries and active selection within countries than bold bets on one versus another. That’s why despite a call for China’s “decoupling” from the US and some pundits promoting investors selling off China to buy India, we’re far from abandoning China as an investment, but happy to back companies in each market that embody the “growth at a reasonable price” we find presently abounding in emerging markets of all stripes. At the same time, we think it’s legitimate to ask whether China may be considered separately from the rest of EM—a subject we address in the webinar “Part 2: Kicking the Elephant Out of the Room—The Case for EM ex-China.”