China’s Deflation Dilemma – Coming to the US?

US inflation and the related worker shortage have clearly been the top concerns for small businesses for the past 2 years. The US and global stimulus efforts created artificial demand far in excess of supply which caused these concerns to manifest. While too much demand may be a good problem to have in the short term, the resulting high inflation rates trigger tighter credit and eventually contracting demand as the Fed fulfills its goal of price stability. The Fed Funds rate journey to 5.25% has reduced inflation as well as banks willingness to make loans that are needed for a growing economy. 

A cyclical slowdown phase in economic activity is expected as we move into 2024 which should continue to weaken inflation pressure. More disinflation should filter in from China’s deflating economy since they garner the largest share of US imports at 17% . The culprit of Chinese deflation is a mismanaged command economy and the extended zero tolerance Covid policies that instilled a wave of conservative consumer behavior.  China’s housing, exports, transportation, and food sectors have been the hardest hit. Some of this Chinese deflation of finished goods and raw materials like Copper will be exported to the US. It’s bad news in terms of global demand near term, but good news for aiding the Fed’s goal of 2% inflation in the US.

Sticky US inflation due to housing and services will be hard to normalize, but many components in the Consumer Price Index (CPI) are already deflating. As we mentioned in July, we supported all of the Fed rate hikes until July and hopefully they will move to a longer term pause mode as long as inflationary trends continue lower to avoid a hard landing in our economy next year.

The unheralded real concern isn’t the current cost of credit and interest rates, but liquidity. The Fed has been reducing its balance sheet by about $80 billion per month. This reduction in securities shrinks cash reserves at US banks and limits their ability to make loans and investments.

Falling bank reserves and higher borrowing costs are a medium-term negative for stocks while the progress on reducing inflation is setting up a more Bullish picture once the Fed hints that rate hikes and the draining of reserves are over. The tech inspired equity surge through the end of July was well timed with our illustrated outline for the time and price window of a summer top in the stock market. The short-term seasonal road map we update (below) had expected a final summer peak around July 19th/21st and the 28th with the first leg correction lows due in the August 4th to 11th timeframe before a brief bounce. While new highs before year end are possible, our focus has been the shift in July to a more defensive mode with excess cash in T-Bills. Our timing for cyclical lows is still targeting late August to early September as well as October. If our proprietary set of technical indicators become oversold during this period, we would move our model portfolio to 100% invested. Currently we do not expect a full test of the 200-day moving average as earnings and multiples stay elevated.

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