In a recent discussion, analysts Alf and Andreas touched upon various topics such as China’s GDP report, Europe’s economy and inflation outlook, the ECB’s reaction function, onshoring and friend sourcing in the supply chain industry, risks to European banks from declining commercial real estate, and entering an active FX position.
China’s economy appears to be rebounding as the first quarter GDP report shows positive signs. Although there are concerns about political risk and geopolitical turmoil due to the Russia situation, there is an overwhelming consensus that China’s consumption is coming back, positively impacting financial markets overall. Strong March retail sales data indicate that consumer optimism is growing, though concerns remain about whether this growth is limited to state-owned sectors.
The discussion also highlighted the positivity around Europe’s economy and the recent inflation report in the UK. Over 80% of the European CPI basket is running at an annualized inflation rate of over 3%, suggesting that the macro cycle may be responsible for current inflation rates rather than just energy or supply factors. This trend is widespread across Europe, but it remains to be seen whether the positivity around the European economy remains sustainable in the long run.
The European Commission’s survey on price expectations from service and manufacturing companies in the Eurozone shows that about 18% of companies expect to raise prices over the next few quarters. While this figure is down from over 60% in previous quarters, it still signals a possible rise in inflation. Analysts suggest that inflation may range from 3.5% to 4% by year-end, which may still be an elevated level.
The ECB’s reaction function was compared to that of the Federal Reserve, with analysts stating that it lacks relative to the Fed’s function. They believe that the ECB will be late to the cutting party just as they were late to the hiking party. For the ECB to reach peak territory for inflation, a disinflationary trend needs to be confirmed in core inflation. Analysts expect this trend to be confirmed by September or October, giving the ECB a window of opportunity for hiking.
The discussion also covered the idea of onshoring in the supply chain industry. Rather than onshoring, CEOs are considering more diversified offshoring to spread out their risks. They also touched on the concept of friend sourcing, which involves insourcing parts from China that were previously outsourced, particularly interesting Indian clients.
Risks to European banks from the declining value of commercial real estate were also discussed. While the price narrative around commercial real estate in Europe is not as bad as in the US, the value of collateral is already declining in Europe, with an index by Green Street showing a 21% decline in commercial real estate prices in Europe in a year. European banks are more exposed to commercial real estate than US banks, and the decline in the value of collateral will eventually impact bank balance sheets as a prolonged crisis in commercial real estate.
Lastly, the idea of entering an active FX position was discussed, with one analyst suggesting that belonging to the Japanese Yen may hold some protection value. The analyst also looked at six fundamental variables and concluded that the bar is pretty high for the Eurozone to surprise the spread expectation, so it may not hold once the credit crunch arrives. The main determinants of FX price for the short to medium term include the relative terms of trade, interest rate differential, and sentiment around the macro cycle and markets in a relative basis.