Receive free market updates by signing up for our myFT Daily Digest email. Stay updated on the latest news in the markets with our Unhedged newsletter. Good morning! It’s CPI day again, and if you’re in finance, it feels like the monthly CPI numbers are released every week. However, today’s report, along with next month’s, is expected to be cool. The concern lies with a potential autumnal bounce in inflation. Reach out to us at [email protected] and [email protected] to let us know your concerns.
In yesterday’s article, we discussed China’s deflation and its potential impact on the US. The chart displayed the value of Chinese exports (blue line) and an export price index (pink line) to illustrate how price cuts are supporting exports. This raises the question: Can China export deflation to the US? Importing some Chinese deflation could be beneficial for the US as it could help lower prices without harming economic activity. China’s spare capacity can help meet strong US demand.
Ed Yardeni of Yardeni Research suggests that Chinese deflation may have an impact on US inflation. He points out the close relationship between US and Chinese consumer inflation before the pandemic and wonders if this relationship will resume as pandemic anomalies normalize. Yardeni also highlights that producer inflation in both countries matches even more closely. Thierry Wizman, rates strategist at Macquarie, believes the Federal Reserve may view Chinese deflation favorably. He suggests that China’s deflation could alleviate concerns about US and European inflation by reducing strain on global supply chains. This “dovish” tone from the Fed since the July 26 Federal Open Market Committee meeting may be influenced by international conditions.
However, Paul Donovan of UBS Global Wealth Management argues that consumer inflation is largely influenced by local factors. Comparing the US and China, with their different consumption baskets and economic structures, is challenging. Donovan also notes that while producer prices are more relevant in terms of global exports, most of what is produced in China is consumed domestically. Dhaval Joshi of BCA Research adds that the deflation China could potentially export may not ease the Fed’s concerns, as the Fed is primarily worried about non-housing services rather than goods prices falling further.
One potential impact of Chinese deflation is on commodity prices, particularly oil. Skanda Amarnath of Employ America believes further increases in energy costs could pose recession risks. The extent to which China stimulates its economy will have global spillover effects, including on the US. If China’s stimulus plans underwhelm, the US could benefit from lower energy costs. However, an aggressive Chinese stimulus could lead to an unwelcome increase in oil prices.
Moving on to the topic of CRE mortgage REITs, we discussed yesterday how these companies face a challenge of interest rate spread compression. While these REITs make floating-rate loans, passing on the full increase in interest rates to borrowers could cause some borrowers to struggle financially. As a result, the profitability of the REITs, as measured by rate spreads, has not grown as fast as interest rates. This has implications for their dividends and market perception of CRE risk. Some of the largest CRE mortgage REITs, such as those managed by Blackstone, KKR, and Starwood, trade at a small discount to book value due to their solid business models. However, other CRE mortgage REITs trade at significant discounts and have lost substantial market value since the start of the pandemic.
The underlying issue for these REITs is spread compression. Granite Point, for example, experienced a significant decrease in its net interest income spread in the most recent quarter compared to two years ago. As a result, the company had to hold more cash to meet debt covenants as CRE valuations became unstable. It is noteworthy that the discount at which Granite Point trades reflects market concerns, as buildings are being repossessed and covenants are being adjusted in the industry. The key lesson here is that the flip side to floating rates is credit quality.
In conclusion, while Chinese deflation may have an impact on US inflation and commodity prices, the relationship between the two countries is complex and difficult to measure. As for CRE mortgage REITs, interest rate spread compression and credit quality play a significant role in their performance. The largest REITs with solid business models trade at smaller discounts, while those facing challenges trade at larger discounts due to concerns about their ability to meet debt covenants.
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