Commentary on Political Economy

Monday 8 April 2024



Today’s Points:

Time for the Inflation Game Again

If there’s any one single reason why interest rates aren’t already falling across the developed world, it’s because inflation isn’t obediently falling as expected. It’s not surging either, but seems to have stalled at a disappointingly high level. Nobody much seems to see that changing much when the numbers for March are released Wednesday. Core inflation is expected to be virtually unchanged, while higher oil prices are projected to increase headline inflation: 

That’s a shame because there is a recent distressing trend of rising month-on-month inflation that beats expectations, as illustrated here with a terminal chart: 

Despite the way the world was taken unaware by the spike in inflation that took shape in the year after the pandemic, forecasters have done a better job than many realize. The following chart was produced by my colleague Michael McDonough. It maps actual core inflation numbers against the median expectation for that number as shown by the Bloomberg survey. Pre-pandemic is in blue, and the last 12 months appear in yellow — but the key point is that forecasts are no less accurate now than pre-Covid, and they continue to be pretty accurate:

So, if inflation surprises with a decline, that’s likely to have quite a galvanizing effect on markets. The 10-year Treasury yield now appears to have consolidated above 4.4%; if core inflation dropped to only 0.2% last month, yields could come down swiftly.

Meanwhile, inflation feeds directly into the political debate. The US presidential election is still seven months away, but the result will have an immense impact on markets and economies around the world. Oddly, though, that debate now appears centered on food, over which politicians and central banks have very little control. The independent presidential candidate Robert F. Kennedy Jr. offered this post on X Monday, accusing the administration of “trying to gaslight us into believing that inflation is coming down,” and offered rises in the price of butter, eggs, milk, peanut butter and toilet paper in rebuttal.  

All of these prices are indeed higher than at the beginning of Biden’s term. That doesn’t mean it’s sophistry or “gaslighting” to say that inflation is coming down, because it is. This is how year-on-year food inflation has moved since 1950. It had its worst spike in decades in 2022, but at present food prices are rising no higher that they typically do. Also, note that outright deflation is very rare:

If we really wish to keep playing this game and judge presidents by food inflation, I can offer the following chart, in which I calculated the average annualized food inflation for all the presidents from Eisenhower onward. There is no particular predictable difference between Democrats and Republicans. Food inflation under Biden, at 6.26%, is the highest for any president since Nixon, who presided over 7.9% inflation per year in the era when he decided to leave the gold standard. Yes, Biden’s term has seen very uncomfortably high food price inflation, this causes pain for real people, and it’s legitimate for political opponents to use against him; but it’s not obvious how much government policies have to do with it:

Note that all the postwar presidents experienced food inflation. None oversaw falling food prices. And that shouldn’t be surprising. The Bureau of Labor Statistics’ food price index goes all the way back to 1913. Prices haven’t grown any cheaper for any significant length of time since the Great Depression:

So we should probably be glad there’s no food price deflation at present, as history suggests that only an economic depression can deliver that. That wouldn’t be a good political argument for Biden to use, and it wouldn’t dampen any selloff in the bond market should inflation in March prove to have topped 0.4%, but maybe we should all keep some perspective. 

Blackstone Moves the Market

On a (blissfully) quiet day on the money markets, the mighty private equity group Blackstone created the biggest wave by announcing that it was buying out Apartment Income REIT Corp., one of the biggest real estate investment trusts specializing in residential apartments, for about $10 billion. It represented a premium of about 25% to AIR’s existing share price, and it’s the strongest shot in the arm that the apartment sector has received in the last two years:

The sector remains beleaguered, with Bloomberg’s apartment index still down by more than a third since the beginning of 2022, but enjoyed its best day this year. Why have apartment investments been performing quite this badly? They’ve been subject to the gravitational pull of rising bond yields, just like the rest of the real estate sector. REITs are generally bought for their attractive and relatively safe rental yield; higher bond yields will prompt investors to require dividend yields from their REITs, which means that the price will go down. The relationship since yields started their sharp ascent at the beginning of 2022 has been ironclad. The chart that follows, taken from the terminal, shows the S&P 500 real estate index on one scale, and the 10-year Treasury yield on the other. The Treasury numbers are inverted to show just how strong the inverse relationship is:

This isn’t a uniquely American experience. An equivalent calculation for Europe, using the FTSE EPRA Developed Europe REIT index and the 10-year bund yield, reveals if anything an even stronger relationship:  

That suggests that those who really think the European Central Bank will cut rates before the Fed might want to back that belief by buying European REITs. As for Blackstone, its purchase was greeted as evidence that the bottom of the market was in and that it was time to buy. But even Blackstone is having difficulties with higher yields. Its flagship real estate income trust, an unlisted entity designed for wealthy clients, last year paid out more in dividends than it received in cash flows, which certainly implies that higher yields are making it harder for the economics of the business to add up. 

Meanwhile, if rates really are staying higher for longer, which in the US certainly seems ever more likely, that could be a serious problem for American office property, on whose business case the pandemic did serious damage. Bloomberg’s index of office REITs has recovered a bit since the nadir, thanks in large part to the significant fall in yields during the last quarter of 2023. But that rise has stalled, and the index is currently at a level it first reached way back in 1997:

This could of course be read as a sign that the time is right to buy. Someone with money in their pockets, like Blackstone, might want to dive in and purchase lots of office space while it’s cheap. It also suggests that office valuations have dropped so grievously that any loans backed by them are in serious trouble. Commercial real estate was the topic of the moment for a while after several regional banks failed in March last year. Bond yields are higher now. There are opportunities in real estate, which Blackstone has maybe identified. There are also risks.

China’s Growth Conundrum

China’s growth story post-pandemic restrictions is a complex one. An economic recovery is gradually unfolding, with manufacturing as a fulcrum. The story looks good at first glance, but Points of Return’s coverage of China has detailed why Beijing’s outlook remains uncertain. 

Investors perked up when March’s Manufacturing Purchasing Managing Index surprised to the upside with new orders moving into expansion territory. This ought to offer some respite from the property sector’s problems, but a more pertinent question is whether this recovery is being driven by a surge in domestic consumption. To answer that, it makes sense to look at how seasonality impacted the March PMI. Clocktower Group shows in this chart that over the last six years. the PMI has risen by an average of 1.6 in the month following the Spring Festival holiday, bar the pandemic:

Further, external demand, especially from places like the US and Korea, might partially explain the manufacturing uptick — and with the gulf between China and the West widening, there’s little room for it to grow. If anything, there’s a greater chance of demand falling. Treasury Secretary Janet Yellen’s talks in Beijing don’t seem to have yielded any major breakthroughs, and of course a returning President Trump could be expected to impose fresh trade sanctions next year.  

His threat to level a whopping 60% tariff on all imports from China is daunting enough. In the last four years alone, medium-to-long-term loans to industry in China have shot up 2.4 times, increasing by between $1.5 trillion and $2 trillion. At the same time, the country’s export price index is near the lowest seen during the Global Financial Crisis in 2009 — a cause of concern that Yellen highlighted

Her fears are influenced by Beijing’s actions in the early 2000s, when cheap goods flooded Western markets. Now, as Neelkanth Mishra of India’s Axis Bank points out, China’s key advantage could be its willingness to overinvest capital, rather than cheap labor: 

When China had surplus labor, but lacked sufficient capital, it outcompeted labor-intensive industries globally. Given its larger economic size now, its competitiveness in capital-intensive industries can now be a threat to industries globally.

Are these concerns overblown? Bloomberg Economics’ Gerard DiPippo suggests that China’s overcapacity is merely a risk rather than a reality in sectors like electronics and machinery, even if falling producer prices “show it’s a live issue at the aggregate level — especially as past overbuilding in real estate drags on demand for construction materials.” 

Whatever risk China’s overcapacity presents is one that the West can barely afford. It reeks of déjà vu. Yellen’s warning to Beijing over the potential flooding of markets with cheap goods is not an isolated incident. The European Union and Brazil have conducted similar scrutiny. 

In the face of all these probes, China’s best bet lies in a shift in macro policy. External demand will, plainly, yield less fruit for China in the future. Shoring up domestic demand is urgent; the share of loss-making firms is almost returning to levels seen in the early 2000s. A wager with the West will likely have one loser — more likely, that will be China.

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