It isn't just artificial-intelligence euphoria that has powered markets higher. There is a benign inflation narrative that has taken hold in markets across the world.
Inflation levels have come down faster than expected, not just in the United States but globally.
That observation, in turn, powered the belief that central banks could cut interest rates sooner rather than later — because inflation is going away — and possibly cut by a lot.
The situation in China has been a contributor, perhaps a big one, to falling inflation levels.
With China's economy slipping into deflation for the first time in decades, China imports less oil and consumes fewer raw materials. In large part because of China's slump, the Bloomberg Commodity Index has fallen to multi-year lows.
China's export prices are also falling, which means lower-priced imports for China's trade partners.
With Chinese consumers battered by real estate losses and Chinese businessmen discouraged by the suffocating hand of the state, Xi Jinping is trying to counter weakness at home with lower-cost Chinese goods sold abroad.
The government can lower the cost of exports by ordering state-controlled banks to lend more to exporters with instructions to lower their prices, creating incentives for higher volumes of goods shipped (with volume increases spurred by lower prices), and so on.
This creates disinflationary (inflation levels that are positive but declining) or outright deflationary (prices that are falling, period) pressures for countries that import China's goods. As of year-end 2023, Chinese export prices had fallen nearly 10% year-on-year.
Today the monthly Personal Consumption Expenditures (PCE) report was released.
The PCE report is closely watched because it is considered the preferred inflation measure of the Federal Reserve, making it the data set they pay the most attention to.
While the latest PCE data was in line with expectations, it also showed the "core" PCE rate, which excludes food and energy, rising more than the "headline" PCE rate, which has food and energy added in. (Twelve-month core PCE and Headline PCE were 2.8% and 2.4% respectively, with core PCE up 0.4% on the month and headline PCE up 0.3%.)
The results are amusing because one of the rationales for citing "core" PCE — the measure that excludes food and energy on volatility grounds — was to create a measure that had less inflation baked into it, rather than more, as compared to the "headline" number.
Now, though, food and energy prices are contributing on the disinflationary side, both on a month-on-month and year-on-year basis. A fair portion of that comes down to China too, by way of its weak import demand.
It makes sense to wonder how much longer China can export deflation to the rest of the world — or what happens if the China slump gets even worse.
In simplified terms, China's economy is drowning in debt. Most of this debt does not show up in China's official debt-to-GDP statistics, but that is because the debt is mostly held at the regional and local level.
Beijing's top-down control of the system, coupled with intervention in every financial crisis (nobody is allowed to go under) makes all China debt a kind of de facto government debt regardless of where it originates.
This means that, while China does not have financial crises like other countries, the whole system is at risk of a kind of meta-level financial crisis if the debt problem gets so big and so serious that China's whole economy grinds to a halt.
In the event that happens, long-time China observers think China will be forced to devalue its currency, i.e., dramatically lower the value of the Chinese renminbi versus the dollar.
That, in turn, would export another major blast of deflation to the rest of the world, as Chinese goods would grow dramatically cheaper still — and possibly kick off a round of ferocious trade wars, the likes of which haven't been seen since the 1930s.
Until next time,
Justice Clark Litle Chief Research Officer, TradeSmith
TradeSmith is not registered as an investment adviser and operates under the publishers' exemption of the Investment Advisers Act of 1940. The investments and strategies discussed in TradeSmith's content do not constitute personalized investment advice. Any trading or investment decisions you take are in reliance on your own analysis and judgment and not in reliance on TradeSmith. There are risks inherent in investing and past investment performance is not indicative of future results.
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