Did you miss Monday’s FEAR post?

Bond-Yield Breakout Is Much More Than Inflation Another edifice of the post-Volcker era of stability is cracking.

(…) The Treasury market is looking intimidating again, and politicians should take notice, as should everyone else.

This selloff is more complicated and ominous than some. It’s also not limited to the US. Bond markets in the bigger European economies are also testing a high made late in 2023. There was a belief that policy rate cuts, made by all the main central banks, would ensure that remained the peak. It’s now coming into question. (…)

Fears of rising inflation, which eats away at the value of future income streams from the bonds, logically raises yields. Inflation expectations as gauged by the breakeven point between fixed and inflation-linked bond yields have ticked up of late, but in the bigger picture they remain remarkably stable. This shows the implicit expectations for the next five years, and for the five years after that (a measure the Fed cares about a lot). They suggest that the bond market is still confident that inflation is back in the bottle:

The latest data, with the last readings on unemployment and inflation for 2024 due on Friday and next Wednesday, do give reason for concern. The Institute of Supply Management’s survey of the services sector showed a sharp increase in the proportion of managers complaining about rising prices paid. As inflation is currently centered almost entirely in services, that is a problem. Moreover, this measure in hindsight provided a great early warning in 2021 that inflationary pressure was brewing:

Meanwhile, there has been a surprisingly strong jump in the number of US vacancies recorded in the JOLTS (Job Openings and Labor Turnover Survey). However, Samuel Tombs of Pantheon Macroeconomics points out that this number is noisy (as Richard Abbey noted yesterday), and that data on job openings from the Indeed web-based recruitment site suggest that vacancies are stabilizing. During this decade, the Indeed measure has provided a smoother ride while working as an excellent early warning for the JOLTS:

So if this isn’t a straightforward recalibration of expectations for the Fed and inflation, why the rise in yields? It’s best to look to the term premium, an infuriating concept that refers to the extra yield investors require to take the risk of lending long into the future, and with it the risks that interest rates will change over that time. Colleagues Mike Mackenzie and Liz Capo McCormick have a nice explainer here. The point of the concept is to explain any rises or falls in yields that can’t be put down directly to the Fed. Interestingly, after a long period when the term premium was negative, it’s now its highest in almost 10 years (according to the Adrian Moench Crump term premium maintained by the New York Fed that is the most widely followed measure):

Why is it rising? Some political risk is in there. A Republican clean sweep has raised the threat of fiscal irresponsibility; bond markets prefer gridlock. The policy uncertainty that surrounds the return of Trump will naturally prompt investors to demand a higher term premium.

Beyond that, there are the forces of supply and demand. Companies have celebrated the new year with a splurge of new issuance, which naturally tends to raise the yields that all bonds must offer. The Treasury under Janet Yellen has raised far more of its debt through very short-term borrowing than usual. That has the effect of reducing the supply of longer bonds and, therefore, reducing their yield. The Trump nominee to succeed her, Scott Bessent, wants to shift back toward longer-term issuance, which will naturally increase supply and hence tend to drive up yields. Investors can see this coming.

The most important issue may be the secular trend. For decades after Paul Volcker tamed inflation in the early 1980s, the 10-year yield trended downward in the most predictable and important pattern in global finance. Whenever the yield rose to threaten the pattern, a crisis — Black Monday, the Orange County derivative disaster, the bursting of the dot-com bubble, the Global Financial Crisis — would erupt, and yields would drop. That is over. And while it’s never wise to make too much of drawing lines on charts, this latest rebound in yields suggests that a new trend is taking shape, as I’ve indicated here:

Demographics can explain this, as can what appears to be a return to inflationary psychology and worries about whether the US fiscal situation is sustainable. The point for now is that the balance of forces is pushing yields upward. The downward trend was in many ways the governing force of international capital markets for more than three decades; it might make sense to get used to the notion that yields will tend to trend up, not down, for the foreseeable future, and change conduct accordingly.

About the November JOLTS:

The November JOLTS report offered another tentative sign of labor demand stabilizing. Job openings at the end of November rose to a six-month high of 8.1 million, consistent with the recent leveling off in Indeed job postings. That said, turnover metrics suggest both employees and employers remain in a holding pattern. The share of workers in November voluntarily quitting their job fell back to its cycle low of 1.9%. Meantime, employers remain reluctant to let go of existing workers, but also reluctant to bring on new workers. The layoff rate, at 1.1% in November, remained just below its pre-pandemic average, but the hiring rate fell back to 3.3% and is still hovering near levels unseen in more than a decade. (…)

On trend, both JOLTS and Indeed overall job postings are roughly 10%-11% above their pre-pandemic marks. The sideways trend in small business hiring plans through the second half of last year and their post-election jump has further allayed some fears of continued cooling in labor market conditions. That said, signs of stabilization in labor demand are still tentative. New job postings from Indeed continue to slow sharply and were just 7.4% higher in December than in February 2020. A year ago in December 2023, new job postings were still 43% higher than their pre-pandemic level.

The rise in job openings paired with November’s 161K increase in unemployment resulted in a small uptick in job openings per unemployed person to 1.13 from 1.12 in October. This leaves one of the Fed’s favorite metrics of balance in the labor market cooler than 2018–2019 levels but still above the 1.00 ratio that indicates there are more jobs available in the economy than workers currently seeking employment. (…) (Wells Fargo)

  

November’s jump in Job Openings looks suspicious vs Indeed’s more recent data (through Dec. 20):

Monday’s Services PMI from S&P Global said that “a rise in staffing levels ended a four-month sequence of job cuts, but it was still only modest.” The ISM Services employment component edged down (-0.1pt to 51.4).

The ISM also revealed that “The prices-paid index jumped from 58.2 in November to 64.4 in December.”

S&P Global’s was more informative and reassuring:

There were further signs of cost pressures moderating in December as the pace of inflation eased for the third consecutive month to the weakest since last February. Input prices still increased markedly, however, and at a pace that was faster than the pre-pandemic average. A number of respondents mentioned higher shipping costs, while others reported wage pressures.

In response to higher input costs, companies increased their own selling prices. The rate of inflation remained modest, despite quickening slightly from that seen in November.

Quits rate versus employment cost growth

Source: Macrobond, ING

Ed Yardeni:

The Bond Vigilantes aren’t buying the Fed’s esoteric narrative that the federal funds rate (FFR) needs to be cut because the so-called neutral rate of interest is much lower than the prevailing 4.33%. What matters more to them is that inflation in the core services components of the CPI and the PCED remains sticky well above 2.0%. Long-term yields may continue rising until the Fed acknowledges the economy’s strength and officially hits the FFR pause button.

Real 10-Y yields (1.81%) are almost back to 2.0%. Seems decent to me but productivity better be present…

Markets Sound Alarm Over Deflationary Spiral in China Investors are increasingly concerned that China risks sliding into an economic malaise that could last decades.

Investors in China’s $11 trillion government bond market have never been so pessimistic about the world’s second-largest economy, with some now piling into bets on a deflationary spiral mirroring Japan’s in the 1990s.

Yields on Chinese sovereign bonds maturing in 10 years have tumbled in recent weeks to all-time lows, creating an unprecedented 300-basis-point gap with US peers, despite a slew of economic stimulus measures announced by President Xi Jinping’s government.

The plunge, which has dragged Chinese yields far below levels reached during the 2008 global financial crisis and the Covid pandemic, underscores growing concern that policymakers will fail to stop China from sliding into an economic malaise that could last decades.

If the bond market is right, the implications would be profound. An extended bout of deflation would hobble one of the world’s biggest economic growth engines, add new strains on social stability in the second-most populous country and exacerbate capital outflows that led to a record exodus from Chinese financial markets at the end of last year.

In a sign of how seriously investors are taking the risk of Japanification, China’s 10 largest brokerages have all produced research on the neighboring country’s lost decades. Richard Koo, an economist well-known for drawing parallels between the two countries, said he has been approached by Chinese companies and think tanks to share his views. Goldman Sachs Group Inc. this week said Japan’s case offers a “valuable playbook” for Chinese stock investors who’ve been rattled by the worst start to a year in nearly a decade.

While an echo of post-bubble Japan is far from certain, the similarities are hard to ignore. Both countries suffered from a real estate crash, weak private investment, tepid consumption, a massive debt overhang and a rapidly aging population. Even investors who point to China’s tighter control over the economy as a reason for optimism worry that officials have been slow to act more forcefully. One clear lesson from Japan: Reviving growth becomes increasingly difficult the longer authorities wait to stamp out pessimism among investors, consumers and businesses. (…)

“The bond market is already telling the Chinese people: ‘you are in balance sheet recession’,” said Koo, chief economist at Nomura Research Institute. The term, popularized by Koo as a way to explain Japan’s long struggle with deflation, occurs when a large number of firms and households reduce debt and increase their savings at the same time, leading to a rapid decline in economic activity. (…)

Regardless of one’s views, Japan’s fate during the lost decades between 1990 and 2010 offers a stark warning for investors in Chinese assets.

The Nikkei 225 index lost more than 70% of its value over that period, compounding the pain of banks and companies as debt-to-equity levels ballooned. It took the benchmark more than 30 years to reclaim its 1989 peak, a feat achieved last year only after a lengthy period of extraordinary monetary stimulus, a paradigm shift in corporate governance, and a long-awaited revival in inflation. (…)

Some, like veteran emerging-market investor Mark Mobius, believe China has the tools to avoid following Japan’s fate. “Since the government has an outsized control over the economy, they have the ability to implement financial measures designed to reduce or even eliminate many of the negative elements,” he said. (…)

Japan’s economy only started to respond positively once policymakers “finally began to directly transfer funds to the people’s pockets,” rather than plow money into infrastructure and companies, said Jesper Koll, an expert director at Monex Group Inc., who has been researching Japan for decades. It “took basically 20 years before politicians learned that lesson — I hope China’s leaders have learned this lesson and have the wisdom to boost the people’s purchasing power.”

China Expands Consumer Subsidies to Boost Spending as Tariff Risk Looms Markets seemed unimpressed by the move, extending declines in early afternoon

The National Development and Reform Commission, China’s top economic planner, said Wednesday that the government will include more products in its home appliance trade-in program in 2025, extending state subsidies to microwave ovens, water purifiers, dishwasher and rice cookers.

Consumers who buy new mobile phones, tablets and smart watches will also qualify for a 15% subsidy for products priced at less than 6,000 yuan, or about $819. Total subsidies will be capped at 1,500 yuan per person per year [$200], according to an official notice. (…)

While the Chinese leadership has hinted that more fiscal support will come for the country’s wary consumers, little details have been revealed so far, with all eyes on March’s annual legislature session where lawmakers are expected to approve a stimulus package that includes more aggressive government borrowing.

Besides support for consumer products, the government will also allocate some funds to provide discounted loans for companies to upgrade their equipment, a senior official told reporters at a press briefing on Wednesday. (…)

@WSJ

• China’s currency hits 16-month low on Trump tariff fears

AI CORNER

AI Startup Anthropic Raising Funds Valuing It at $60 Billion Amazon-backed OpenAI rival was valued at $18 billion last year

The deal would make Anthropic the fifth-most valuable U.S. startup after SpaceX, OpenAI, Stripe and Databricks, according to data provider CB Insights. It was valued last year at $18 billion in a round led by Menlo Ventures.

Anthropic is the latest in a string of artificial-intelligence startups that have seen their valuations skyrocket amid a dealmaking frenzy over the past few months.

OpenAI raised $6.6 billion in an October round that nearly doubled its value to $157 billion.

Two other startups, Elon Musk’s xAI and Perplexity, subsequently raised money at substantially increased valuations.

Investors are excited about the potential of generative AI to transform how people work and live and largely unconcerned that most AI startups are losing money because of the high costs of the technology and intense competition.

Tech giants including Meta Platforms and Alphabet’s Google are also investing billions to build their own AI capabilities.  (…)

The startup’s annualized revenue—an extrapolation of the next 12 months’ revenue based on recent sales—recently hit about $875 million, one of the knowledgeable people said. Most of that has come from sales to businesses.

OpenAI told investors when closing its October round that it expected to generate $3.7 billion in revenue last year, in large part from sales of the premium version of ChatGPT to consumers.

FYI:

Anthropic: 68x revenues

OpenAI: 42x revenues

Nvidia: 19.3x forward revenues, 29.6x EV/Ebitda, 35.5x EPS with ebitda margins of 64%, net margins of 56% and return on capital of 74%.

This is a good time to read Howard Marks’ latest memo: On Bubble Watch

DeepSeek Shows Necessity Is The Mother of Invention

The Information writes that the latest update (December 26) to Chinese quant trading firm High-Flyer Capital Management’s DeepSeek Large Language Model had scores on popular benchmarks that in some cases beat models from OpenAI, Anthropic and Meta. By comparison, Meta said it trained its Llama 3 405B model, released in July, using 16,000 H100s, which are more expensive to run than the H800 chips.

High-Flyer says it used just 2,048 Nvidia H800 chips and spent $5.5 million to train the model. The H800 is a dumbed-down version of the H100 chip that U.S. authorities allow Nvidia to sell in China.

Despite restrictions on the sale of advanced Nvidia chips in China, researchers there have been able to make do with weaker and older-generation chips. Their success proves once again that necessity is the mother of invention—and that American researchers probably aren’t getting as much out of Nvidia’s hardware as they could be.

• A Chinese model will surpass leading American AI: Speaking of China, models from the country have been seriously impressing American AI researchers. It doesn’t seem like export restrictions on Nvidia chips have been making much of a dent in the country’s progress, as Chinese researchers have simply gotten more creative with using older Nvidia chips. I believe that in 2025, an AI model from a Chinese lab will surpass leading models in the U.S. on popular leaderboards like LMSYS’ Chatbot Arena. Whether or not it’ll get picked up by AI developers, though, is a different question, given censorship in these models.

Trump Imagines New Sphere of U.S. Influence Stretching From Panama to Greenland The president-elect sees overseas territory as vital to U.S. interests and suggests he isn’t bluffing in threats to take over allies

President-elect Donald Trump’s calls to take control of Greenland, Canada and the Panama Canal reflect his fascination with a 21st-century version of an old idea—that great powers should carve out spheres of influence and defend their economic and security interests by imposing their will on smaller neighbors.

In a press conference Tuesday, Trump outlined a second-term foreign policy agenda that rests not on global alliances and free trade but on economic coercion and unilateral military might, even against allies.

With the Panama Canal and Greenland, he suggested he could use force to take them over. With Canada, he suggested he would hit the U.S.’s northern neighbor with extreme tariffs, leaving it no choice but to submit to annexation. (…)

If Trump does even a portion of what he described—each of which is extremely unlikely—it could mean far-reaching changes in America’s global role, emboldening adversaries and forcing allies no longer assured of Washington’s backing to seek new security and economic arrangements, analysts said. (…)

Asked by a reporter if he would commit to not using military force or economic pressure in his quest to acquire the territories, Trump replied “No, I can’t assure you on either of those two. But I can say this, we need them for economic security.” (…)

“China and Russia are looking at all this like, ‘Go ahead, Mr. Trump, keep talking.’” (…)

Trump’s vow to annex Canada is bluster aimed at gaining leverage before trade negotiations with Ottawa, some advisers say. His threat to take back the canal is a ploy to secure lower prices for U.S. ships sailing through Panama, and his fixation on acquiring Greenland is about gaining access to rare-earth minerals and denying them to China, they add. (…)

To anyone alarmed that Trump might actually do what he says, they point to his pledge during his first run for the White House to make Mexico pay for the wall he wanted to construct along the U.S. southern border—an idea that he stopped talking about as the difficulties of making it happen became clear and other issues took priority. (…)

Some of his advisers acknowledge a sale is unlikely, but an expansion of U.S. presence on the island, through economic investments and a larger military footprint, is a possibility, they say. A decades-old treaty between Denmark and the U.S. gives the Pentagon access to an Arctic base in southern Greenland with an airfield, as well as radar and other equipment used for detecting possible missile launches.

Trump’s advisers are interested in expanding that U.S. presence to counter the growing influence of China and Russia in the Arctic, and believe Washington could negotiate a relationship similar to that enjoyed by tiny island nations in the Pacific, called a compact of free association.

Such an agreement would allow the State Department to negotiate expanded economic and military ties without Denmark surrendering sovereignty. Congressional approval would be required for any such compact. (…)

The waterway is currently administered through the state-run Panama Canal Authority, but two of its seaports have long been run by a Hong Kong-based company, an arrangement Trump says is unacceptable.

The Panama Canal “was built for our military,” and “we gave the Panama Canal to Panama, we didn’t give it to China,” he said. “They have abused that gift.” (…)

Amending the Canadian constitution to dissolve the country and join the U.S. would require unanimous approval from Canada’s Senate, House of Commons and provincial legislatures. A December Leger poll showed only 13% of Canadians want their country to become America’s 51st state, with 82% opposed. Both chambers of the U.S. Congress would also need to authorize a new state. (…)

Advisers close to Trump acknowledge that annexation of Canada is unlikely, and instead suggest the comments are rooted in Trump’s aggressive negotiating style, particularly at this time of transition in Canada, where he seeks to put the incoming prime minister on notice. (…)

FYI: On this day: Panama regains the Panama Canal

On December 31, 1999, the United States officially handed the Panama Canal over to Panama’s government, ending a long saga that had started a century and a half earlier. (…)

In his first State of the Union address in 1902, President Roosevelt made it clear that the canal was a top priority for his administration.

“No single great material work which remains to be undertaken on this continent is of such consequence to the American people as the building of a canal across the Isthmus connecting North and South America,” he told Congress. “It is emphatically a work which it is for the interest of the entire country to begin and complete as soon as possible; it is one of those great works which only a great nation can undertake with prospects of success, and which when done are not only permanent assets in the nation’s material interests, but standing monuments to its constructive ability.”

In 1903, the United States supported a bloodless revolution in the Colombian province of Panama after the Colombian government rejected a U.S. treaty to acquire land in Panama to build the canal. The United States Senate offered $10 million for the land; the Colombian government wanted $25 million.

As the Colombian government sent troops to put down the rebellion, a U.S. warship, the Nashville, appeared with a contingent of Marines off the Panamanian coast, along with other U.S. naval vessels. The next day, Panama declared independence and Roosevelt quickly recognized Panama as a Republic and offered it protection.

Philippe Bunau-Varilla, a French citizen, acted as Panama’s agent and negotiated a new canal treaty with Secretary of State John Hay, which was ratified by the Senate in February 1904. The United States government gave the $10 million offered to Colombia to the Panamanians as part of a new treaty. It also supplied a constitution to Panama that gave the American government the right to “intervene in any part of Panama, to reestablish public peace and constitutional order.” (…)

• EU will defend borders, says French minister in response to Trump’s Greenland threats

Did you miss FEAR?

Also FYI:

The name “Gulf of Mexico” dates back to the Spanish exploration of the region in the 16th century. It is believed that the name was derived from a Native American city called “Mexico”. This naming occurred during the early period of Spanish colonization when conquistadores were mapping and naming geographical features in the New World.

During the early 1500s, Spanish explorers were the first Europeans to extensively chart and document the gulf. They initially referred to it as “Golfo de Nueva España” (Gulf of New Spain) or “Golfo de México. The Spanish maintained exclusive control over the region for more than 150 years, which helped solidify the use of the name.

The name “Gulf of Mexico” first appeared on maps in the 16th century. This cartographic representation played a crucial role in establishing and perpetuating the name internationally. Over time, as more European powers became involved in the region, the Spanish name was adopted and translated into other languages.

It’s important to note that the name “Mexico” in “Gulf of Mexico” does not refer to the modern nation-state of Mexico. Instead, it relates to an indigenous city that bore the name “Mexico”. This connection to pre-colonial Native American geography adds a layer of historical depth to the gulf’s nomenclature.

The International Hydrographic Organization (IHO), of which both the United States and Mexico are members, is responsible for standardizing the naming of seas, oceans, and navigable waters worldwide. Any name change would require agreement from this international body, not just unilateral action by the U.S.

While the U.S. does not have a specific law protecting the Gulf of Mexico’s name, changing it would likely require:

1. Approval from the U.S. Board on Geographic Names (BGN)
2. Congressional action
3. Diplomatic negotiations with Mexico and other Gulf countries

Even if the U.S. were to officially change the name domestically, other countries are not obligated to recognize or use the new name. The Library of Congress, for example, does not change a country’s name unless it is recognized by the BGN, which in turn often follows State Department guidance on such matters.

The name “Gulf of Mexico” has been in use for over four centuries and holds significant historical and cultural value. Changing it could face strong opposition from various stakeholders, including historians, cultural groups, and the general public.In conclusion, while it is technically possible to attempt a name change, the legal, diplomatic, and practical barriers make it an extremely challenging and unlikely proposition. (Perplexity.ai)

Did you miss Monday’s FEAR post?

SERVICES PMIs

USA: Renewed rise in employment as output growth strengthens

The seasonally adjusted S&P Global US Services PMI^® Business Activity Index rose for the second month running in December, reaching a 33-month high of 56.8 following a reading of 56.1 in November.

Companies indicated that client demand had improved, with customers more willing to commit to new projects following the outcome of the Presidential Election.

In line with the picture for business activity, the rate of expansion in new orders also reached the fastest since March 2022 in December. New business was up rapidly in the final month of the year, extending the current sequence of growth to eight months.

A further increase in new business from abroad was registered, although the pace of expansion eased from that seen in November and was much weaker than the growth in total new orders.

The strength of the rise in overall new business meant that backlogs of work accumulated again in December, the third time in the past four months in which this has been the case.

Efforts to limit the build-up in backlogs of work and respond to strong growth of new orders led service providers to take on extra staff at the end of 2024. A rise in staffing levels ended a four-month sequence of job cuts, but it was still only modest.

There were further signs of cost pressures moderating in December as the pace of inflation eased for the third consecutive month to the weakest since last February. Input prices still increased markedly, however, and at a pace that was faster than the pre-pandemic average. A number of respondents mentioned higher shipping costs, while others reported wage pressures.

In response to higher input costs, companies increased their own selling prices. The  despite quickening slightly from that seen in November.

Service providers expect the incoming administration to strengthen business conditions in 2025, leading to growing confidence in the year-ahead outlook for business activity. In fact, optimism was the strongest in a year-and-a-half and above the series average as 44% of firms expressed a positive outlook. Marketing efforts are also predicted to help boost activity over the coming year.

Chris Williamson, Chief Business Economist at S&P Global Market Intelligence

“The US economy ended 2024 on a high according to the latest business surveys. Business activity in the vast services economy surged higher in the closing month of 2024 on fuller order books and rising optimism about prospects for the year ahead.

“Expectations of faster growth in the new year are based the anticipation of more business-friendly policies from the incoming Trump administration, including favorable tax and regulatory environments alongside protectionism via tariffs.

“The improved performance of the service sector has more than offset a continued drag on the economy from the manufacturing sector, meaning the survey data point to another robust expansion of the economy in the fourth quarter after the 3.1% GDP growth seen in the third quarter.

“The strong service sector PMI reading for December sets the US economy up for a good start to 2025 but, with growth as strong as this, it’s understandable that policymakers are taking a more cautious approach to lowering interest rates. However, a key focus in the coming months will be the potential vulnerability of the economy to any major change in the interest rate outlook, especially as financial services activity has been an important engine of growth in late 2024, partly on the anticipation of a further lowering of borrowing costs.”

The Composite PMI is as strong as it gets even without contribution from manufacturing.

What if the latest surge in manufacturing new orders is sustained?

Since the pandemic, manufacturing new orders ($ values) are up 27% but production (black line, units) is unchanged. All prices…

… and imports:

Goldman Sachs

Yet, construction spending on manufacturing tripled (red line above). All data centers! No humans, no widgets, all cloud data!

If there is a multiplier effect from these expenditures, it must be through increased productivity. See the AI Corner below.

But the bond market is not sharing equity investors’ enthusiasm, is it?

The Fed has cut interest rates 100 basis points since September, and over the same period, 10-year interest rates are up 100 basis points. This is highly unusual. Is it fiscal worries? Is it less demand from abroad? Or maybe Fed cuts were not justified? The market is telling us something, and it is very important for investors to have a view on why long rates are going up when the Fed is cutting.

Since the Fed started cutting interest rates in September, financial conditions have eased with a rise in the stock market, a tightening of credit spreads, a decline in the VIX, a rise in inflation expectations, and an appreciation of the US dollar.

The charts below show the net effects of these developments on GDP and inflation using a model of the US economy that is similar to the Fed’s model, FRBUS.

The bottom line is that Fed cuts and associated developments in financial markets will boost GDP over the coming quarters by 1 percentage point and boost inflation by 0.5 percentage points.

In short, there are significant tailwinds in the pipeline to growth and inflation coming from the Fed having started to cut interest rates and the associated easing in financial conditions.

Combined with the ongoing fiscal outlook, we continue to worry more about the upside risks to growth, inflation, and interest rates over the coming quarters. (Apollo)

Eurozone economy contracts marginally in final month of 2024

After signalling the first decline in services output across the single-currency union for ten months in November, the HCOB Eurozone Services PMI Business Activity Index bounced back above the neutral 50.0 threshold to 51.6 in December (49.5 previously). This therefore pointed to a renewed upturn in output across the services sector, albeit one that was moderate and weaker than the survey average (52.6).

The rejuvenation in growth was achieved with little support from new sales, as new business intakes rose only fractionally. Nonetheless, this was the first month since August that demand for euro area services improved. Increased sales were a reflection of domestic client appetite, as new export business shrank for a nineteenth straight month.

Backlog reductions were a means for firms to expand activity, latest data suggested, as outstanding order volumes decreased in December. Euro area services companies remained in hiring mode, stretching the current period of job creation to nearly four years. That said, the rate of employment growth was only fractional and among the softest seen over this sequence.

Sustained hiring came amid a pick-up in firms’ expectations for growth in the coming year. Albeit stronger than November’s 14-month low, the level of optimism was historically subdued.

Services prices continued to rise at a quicker rate in December. Both input costs and output charges saw their rates of inflation accelerate for the third month running to reach five- and seven-month highs, respectively.

The seasonally adjusted HCOB Eurozone Composite PMI Output Index posted in sub-50.0 contraction territory again in December, marking a second successive monthly decline in economic activity across the euro area. At 49.6, the index was up from November’s 48.3, indicating a deterioration that was not only softer than the previous month, but just marginal overall.

Notably, the eurozone’s contraction in December was entirely manufacturing-led as services activity bounced back. However, with the expansion in services limited to just a modest pace, it was more-than-offset by a sharp drop in factory production.

As was the case in November, the big-three eurozone economies of Germany, France and Italy all posted reductions in business activity during the final month of 2024. France was the weakest-performing, followed by Germany, while Italy saw just a marginal decrease in output. The other nations with Composite PMI available, Spain and Ireland, bucked the contraction trend and posted continued expansions in economic activity. Notably, private sector output in Spain rose at the fastest pace since March 2023.

Demand for euro area goods and services declined once again as 2024 came to an end, marking seven straight months of falling new orders. As was the case with output, services companies saw new business intakes rise (albeit only fractionally), but a sharp and accelerated fall in factory sales meant the overall trend in new orders remained a downward one. Euro area companies also received little support from their customers in export* markets, with demand from non-domestic clients decreasing, stretching the current sequence of decline that has been ongoing for almost three years.

Employment across the single-currency market subsequently fell in December, with firms reducing their workforce capacity. In fact, the rate of job shedding was the joint-sharpest in four years (matching that seen in October). Job shedding was again exclusively driven by the manufacturing sector as a fractional and slower uptick in headcounts at services firms failed to counteract factory retrenchment.

Nevertheless, despite lower staffing numbers, eurozone companies were able to reduce their volumes of work-in-hand (i.e. orders received but awaiting completion) during December. Backlogged work has fallen in every month since April 2023.

December survey data signalled an acceleration of price pressures across the euro area. Input costs rose at a pace that was the fastest since July and stronger than the pre-pandemic survey average. Eurozone factories recorded no change in their expenses, whereas services companies saw a notable uptick. Charge inflation for the two monitored sectors combined likewise quickened and hit a four-month high. The composite data did however mask discounting by goods producers, with more aggressive price setting in the services industry driving overall output charge inflation up.

Lastly, the latest survey data showed an improvement in business sentiment, with expectations for growth in the coming year picking up to their strongest since September. That said, when compared with the historical average, confidence remained subdued.

China: Services activity expands at quickest pace since May

The seasonally adjusted headline Caixin China General Services Business Activity Index posted 52.2 in December, up from 51.5 in November. This extended the period of expansion to two years. Moreover, the rate of business activity growth accelerated from November to the fastest since May.

The acceleration of services activity growth was in line with the trend for new business. Incoming new work rose to extend the current period of growth to two continuous years and at a rate that was the fastest in five months. According to service providers, promotional efforts and better underlying demand supported the latest increase in new sales. Sales growth was notably supported by higher domestic demand as new export business declined for the first time since August 2023 amid softening foreign interest.

On the back of faster new business inflows, outstanding work accumulated again. The pace of growth was the fastest in the current five-month sequence in December but remained marginal. Meanwhile, employment fell for the first time since August even with intensifying capacity pressures. This was attributed to both resignations and redundancies according to panellists, with some firms mentioning cost concerns.

Indeed, cost inflation intensified in the latest survey period. Panellists often mentioned rising input material and wage costs had contributed to stronger cost pressures. This marked the first rise in the rate of cost inflation for three months, though it remained only marginal overall. As a result of rising cost pressures, average selling prices increased for the first time since June as Chinese service providers sought to share rising cost burdens with clients.

Finally, sentiment in the Chinese service sector remained positive at the end of 2024 as firms were generally hopeful that business development efforts and supportive government policies can support sales growth in 2025. That said, the level of business confidence eased to the second-lowest since March 2020, ranking just above September’s level. Some businesses expressed concerns over rising competition and the negative effect outlook for international trade.

Commenting on the China General Composite PMI® data, Dr. Wang Zhe, Senior Economist at Caixin Insight Group said:

“In December, the Caixin China General Composite PMI was 51.4, down 0.9 points from the previous month while remaining in expansionary territory for the 14th straight month. Both the manufacturing and services sectors saw increased output, with growth in demand at the composite level outpacing supply for the first time in four months.

“Employment contracted across the board. Price levels were weak, marked by a decelerating increase in input costs while output prices went from growth to decline, dragged by the manufacturing sector. Meanwhile, market optimism weakened.

“Since late September, the synergy of existing policies and additional stimulus measures has continued to act on the market, producing more positive factors. The economy in general remains stable, on the path to achieving the main goals set for 2024.

“That said, it is worth noting that prominent downward pressures remain, with tepid domestic demand and mounting unfavorable external factors. Meanwhile, employment remains sluggish and profit margins have been squeezed, leading to a decline in market optimism. In December, some of the Caixin manufacturing PMI survey’s gauges declined, suggesting more time is needed to assess the consistency and effectiveness of previous policy stimulus.

“The external environment is expected to become more complex this year, requiring early policy preparation and timely responses. In addition, future policy efforts should focus more on increasing household income and improving people’s livelihoods, with particular attention paid to increasing socially disadvantaged groups’ ability and willingness to spend.”

China’s December Home Sales Stay Flat in Sign of Stabilization Value of new-home sales from biggest developers is unchanged

The value of new-home sales from the 100 biggest real estate companies for the month remained unchanged from a year earlier at 451.4 billion yuan ($61.8 billion), compared to a 6.9% on-year drop in November, according to preliminary data from China Real Estate Information Corp. Sales gained 24.2% from a month earlier.

For all of this year, sales from the top 100 builders slumped 28.1%, compared to a 16.5% drop in 2023. (…)

Morgan Stanley expects China real estate sales to drop 12% next year, and home prices to decrease by high single digits in percentage terms from November’s level. Fitch Ratings said prices could fall by 5% in 2025 and new-home sales to decline 10% by area.

China gives government workers first big pay bump in a decade to boost economy

• Millions of government workers get wage hikes to boost spending
• Immediate payout may inject $12-$20 billion into fragile economy
• First nationwide civil servant pay raise in China since 2015

Euro-Zone Inflation Rebounds But Won’t Derail ECB Rate Cuts

Consumer prices rose 2.4% from a year ago in December, up from 2.2% in November and matching the median estimate in a Bloomberg poll. The increase was largely driven by energy costs, which climbed for the first time since July, Eurostat said.

Core inflation, which strips out such volatile components, stood at 2.7%. In the services sector, price growth edged up to 4%. (…)

A separate report from the ECB showed that inflation expectations of consumers increased in November. (…)

Concern about inflation in the services sector remains, however. It’s been stuck at about 4% for more than a year, largely due to rising wages, which play a greater role in that part of the economy than elsewhere.

The ECB doesn’t see this situation persisting. Workers’ pay grew at a slower pace in the third quarter, and early indicators point to a softening in the jobs market. (…)

FYI: Natural gas prices are now more than 50% higher than a year ago, and oil prices are no longer falling. As such, energy will be a significant upward risk to inflation in the first quarter.

AI CORNER

AI Coming To Vegas, Baby, Vegas!

Ed Yardeni is about my age so he remembers the dot.com era when investors blindly bid up shares of any company taking dot com language.

The Q4-2024 earnings reporting season is about to start, led by the big banks. We expect that during their conference calls, company managements will discuss how AI may be starting to boost their productivity. In effect, they’ll be trying to convince investors that every company is now a technology company either producing AI hardware and software or using them.

The AI excitement will be palpable this week. As Vince Vaughn famously said: “Vegas, baby, Vegas.” The Consumer Electronics Show, or “CES” for short, kicks off Monday evening in Las Vegas and runs through Friday, January 10. It will undoubtedly be mostly all about AI. (…)

On December 9, Google’s stock price rebounded off its 200-day moving average after the company announced that Willow, its latest quantum computing chip “demonstrates error correction and performance that paves the way to a useful, large-scale quantum computer”. The press release didn’t specify how long the way might be to get there. When we do get there, quantum chips might replace GPU chips to power AI software.

When AI is combined with quantum computing, science fiction will no longer be fiction. It’s hard to predict the impact of this development on our economy and society. However, it will probably be bad news for blockchain and the cryptocurrencies that depend on it because encryption codes will be easy to hack. For now, that possibility isn’t stopping bitcoin’s ascent.

During the upcoming earnings reporting season, we expect to hear lots of guidance about the likely impact of AI on earnings. The question is whether the spending on AI technologies is showing signs of paying off in higher corporate profit margins.

Industry analysts are currently estimating that S&P 500 operating earnings per share rose 8.2% y/y during the last quarter of 2024. We are expecting a 10.0% increase. During the four quarters of 2025, the analysts are expecting double-digit increases: Q1 (11.0%), Q2 (10.8%), Q3 (12.0%), and Q4 (16.8%). That’s a 12.5% increase in 2025.

We are forecasting a 17% increase because we expect the S&P 500 profit margin to rise to a record high this year.

In my yesterday post FEAR:

But profit growth is not that strong outside of Tech and Communication Services. These 2 sectors are expected to show combined earnings up 22.6% in 2024 on revenues up 12.8%. The other 9 sectors combined: +4.1% on revenues up 3.0%.

Yet, analysts see the same 9 sectors earnings up 11.8% in 2025 on revenues rising 11.7%. Most of this growth is expected to come from Health Care (+20.8%) and Industrials (+19.8%).

One has to wonder how analysts are incorporating the potential Trump administration policies on health care costs and import tariffs at this time.

FYI, in March 2024, analysts expected Health Care revenues to rise 13.5% in 2024. It now looks like +8.3%, but they are expecting +13.4% in 2025.

Industrials revenues were expected to grow 11.2%. It now looks like –3.9%, but they are forecasting +14.7% for 2025.

I would not bet much on these 2025 numbers…

• The AI boom’s economic impact is starting to show up

(…) If you focus on the expenditures for software, technology hardware, industrial equipment and data center structures at the heart of the AI boom, you’re looking at nearly 6% of US GDP as of the third quarter of 2024. That number is likely to rise further in the coming quarters. If so, we would surpass the share of GDP that the tech-industrial-telecom boom of the late 1990s reached at its peak back in 2000:

Source: Skanda Amarnath

If recent and upcoming months to be banner ones for capital expenditures, as megacap-tech firms have been guiding, we are likely to see it show up in the relevant GDP components, albeit with a potential lag. At something close to 7% of the US economy at the end of 2025, it’s plausible and arguably even likely, that the AI boom would be on a par with the share of the US economy housing investment represented at its 2005 peak. (…)

Unlike aggregate consumption, which is a large share of the US economy but very smooth and relatively acyclical, AI-relevant GDP components have exhibited more volatility in the not so distant past.

Source: Skanda Amarnath

As of now, the aggregate of software, tech hardware, industrial equipment, and data center expenditures is growing at a 10% clip. While the future is always uncertain, it’s at least plausible that the growth rate swells further over the next two to five quarters. A rising share of GDP alongside an accelerating growth rate would mean higher real GDP contributions from these segments, in the short run at least.

Source: Skanda Amarnath

In the third quarter of last year we saw these segments contribute 0.5% to real GDP growth. It’s not a number to sneeze at but also meaningfully lower than the 1-1.2% contribution to real GDP growth seen in the late 90s tech boom. (…)

So much of the rise in IT-relevant GDP segments up until this point has been subtle. The fact that information technology spending went through a one-time level shift up during the pandemic, means it’s back at a share of US GDP not seen since the late 1990s. (…)

Source: Skanda Amarnath

A third year above 2% productivity growth would likely force the Fed to raise its estimates of potential GDP growth. And while I would disagree with drawing a conclusion that it should necessarily imply a higher neutral rate of interest (r*), plenty of other FOMC members have suggested otherwise. Booming AI investment in 2025 has the chance to be yet another catalyst to push up both short- and longer-run expectations for Fed policy.

The other side of the coin to booming tech investment in the coming quarters is that we see subsequent analogues to the 2000-2003 downturn. Contrary to the common conception of it being a shallow recession lasting less than a year, the hangover from the late 1990s tech boom involved persistent multi-year declines in the labor market (as evidenced by the prime-age 25-54 employment rate), real business fixed investment, and the stock market. (…)

For the time being, the AI boom is poised to be a real economy tailwind through much of 2025. In the process of pushing up activity, new bottlenecks may grow more acute, just as we’re already seeing with transformers and the state of the US electricity grid.

Contingently, the more acceleration and outperformance we see in the coming few quarters, the greater the risk of future investment overhangs and real economy weakness. Timing these types of cycles is indeed a mug’s game, but it’s all the more reason to pay close attention in this space.

From Evercore ISI:

Surge in AI mentions across Corporate America, strong Hyper-Scaler Capex, and record Google searches reflect large enthusiasm over AI. Adoption remains muted, though nearing Inflection.

AI has moved beyond chatroom queries, integrating into workplaces and leveraging tools to produce goods and services. Generative AI propels physical and digital automation forward with breakthroughs in Inference Time Reasoning, communication, and training data capabilities.

Freed from hardcoded rules, AI-infused Autonomous Agents can now tackle a broader set of tasks. While oversight remains critical to ensure accuracy, AI’s newfound ability to “think” then “act” underpins our confidence in a 2025 adoption inflection base case.

I am using Perplexity.ai many, many times daily, and my usage keeps rising as I query on all kinds of matters. Googling is mostly out for me. For $20/month for the Pro version, a bargain for me given the jump in productivity. If you wish, use this referral, we will both save $10! https://perplexity.ai/pro?referral_code=9IL19U5E

• Nvidia CEO Pitches Robotics, Cars as Growth Areas to Consumer-Electronics Audience CEO Jensen Huang touts gaming chips, robots, autonomous vehicles and a personal AI supercomputer

Taking the stage at the annual CES conference in Las Vegas, Huang showed “physical AI” tools that he said would help robots learn using simulated environments that closely mimic the real world. That could bring more automation to warehouses and factories and boost a humanoid-robot market that the company said could be worth $38 billion in the next couple of decades. (…)

Among Huang’s other announcements:

• Nvidia will make a personal AI supercomputer called Project DIGITS. It will be a desktop computer with a version of its latest Blackwell AI chip inside, and will start at $3,000. The computers are aimed at AI researchers and data scientists, allowing them to work on AI models without having to tap Nvidia’s cutting-edge AI chips housed in data centers.
• New AI “blueprints” that make it easier to create and deploy AI agents to do things such as analyze video feeds and generate blog posts. One of Nvidia’s blueprints has users feed in multiple PDF files from which it creates a podcast “narrated in a natural voice,” according to a company release.
• A new generation of graphics chips for videogamers. The hardware, which costs up to about $2,000, enhances resolution and framerates for the most demanding games in part by leveraging AI, executives said. The chips are to be available for desktop computers this month, with laptops coming in March.

The FT has a lot more:

• Cracking the technological challenges involved in deploying robots at scale will pave the way to “the largest technology industry the world has ever seen”, said Huang.
• Nvidia said the field of robotics had reached a technological tipping point, as AI accelerates and fine-tunes the process of simulating the physical world and generating the vast amounts of data needed to train robots. In the next two decades, the market for humanoid robots alone is expected to reach $38bn, according to the company.
• Nvidia announced a suite of foundational AI models on its new Cosmos platform, which developers can use for free to generate data and build their own models. Nvidia said the foundation models, which it said were trained on 20mn hours of video data, were as fundamental a technological development as the large language models that underpin apps such as OpenAI’s ChatGPT. It pairs with Nvidia’s Omniverse platform, which is used to run simulations of the physical world. “What [those models] are doing for language, we can now do for understanding the physical world,” Rev Lebaredian, Nvidia’s vice-president for Omniverse and simulation technology, told the Financial Times. While data on the physical world is much harder to gather and process than text, Lebaredian said “it’s a necessary part” of the company’s mission. “The big takeaway [from Huang’s CES speech] is that this moment is going to be a special one,” he added. “I think this year is an inflection point where we’re going to see this acceleration of physical AI and robotics.”
• Nvidia also unveiled a collection of foundation models for humanoid robots, called the “GR00T Blueprint”, which it said would “supercharge” the development of robots, as well as new tools for developing and testing fleets of factory and warehousing robots and training autonomous vehicles. Autonomous vehicles “will be the first multitrillion-dollar robotics industry”

 Tencent Shares Decline After US Adds Company to Chinese Military Blacklist Firms on Chinese military list face reputational damage

The US has blacklisted Tencent Holdings Ltd. and Contemporary Amperex Technology Co. Ltd. for alleged links to the Chinese military, targeting the world’s biggest gaming publisher and top electric-vehicle battery maker in a surprise move weeks before Donald Trump takes office.

CATL, a major supplier to Tesla Inc., joined Tencent on a Federal Register of entities deemed to have ties with the People’s Liberation Army. Both companies protested their inclusion as a mistake, saying they have no ties with the military. (…)

While the Pentagon’s blacklist carries no specific sanctions, it discourages US firms from dealing with its members. (…) And the agency added oil major Cnooc Ltd. and Cosco Shipping Holdings Co., both of which have been previously targeted by Washington. (…)

Tencent, China’s most valuable company, has big investments in or deep ties to developers from Fortnite studio Epic Games Inc. to Activision Blizzard Inc. The company founded by billionaire Pony Ma is considered one of the pioneers of the internet and private sector in China, creating a so-called everything app that Elon Musk has held up as a model for X.

During the first Trump administration, the US government sought to ban WeChat — a messaging service that’s evolved into a payment, social media and online services platform — on grounds that it jeopardized national security. (…)

In August, lawmaker Marco Rubio — nominated to become US secretary of state in the Trump administration — asked the Pentagon to target CATL because of its potential to become a vital supplier to the PLA. (…)

CATL accounted for over one-third of global battery shipments in the third quarter of 2024, according to Seoul-based SNE Research, more than double that of runner-up BYD Co. Several US companies, including Ford Motor Co., source from the Chinese firm. (…)

The Chinese firm said it was “a mistake” to include its name on the Defense Department list. It said in a statement that it’s not engaged in military-related activities, was privately founded and became a publicly listed company in 2018. (…)

Some Chinese firms have successfully fought to get removed from the US list. In 2021, smartphone giant Xiaomi Corp. managed to reach an agreement with the US government that set aside its designation as a Chinese military company. Last year, Advanced Micro-Fabrication Equipment Inc. was removed, doing away with a label the firm described as an “irrational” designation. (…)

The Chinese military company list stems from an order signed by Trump in late 2020 that barred American investment in Chinese firms owned or controlled by the military. It was part of a broader effort to rein in what the US had described as Beijing’s abusive business practices.

The Defense Department noted in the Federal Register filing that companies included on the list are entitled to request reconsideration.

In the same statement, the department removed several firms from the list, including AI firm Beijing Megvii Technology Co., China Marine Information Electronics Co., China Railway Construction Corp., China State Construction Group Co., China Telecommunications Corp. and ShenZhen Consys Science & Technology Co.

• China adds 28 US entities to export control list

The companies on the list include General Dynamics, Boeing Defense, Space & Security, Lockheed Martin and Raytheon Missiles & Defense.

China is also banning the export of dual-use items to these companies starting on Thursday, the ministry said.

Ozempic economics: How GLP-1s will disrupt the economy in 2025 Weight loss drugs are saving lives, shrinking waistlines and shaking up the economy.

(…) As of May, roughly 1 in 8 American adults had tried GLP-1 receptor agonists (GLP-1s for short). This percentage has almost certainly grown since then, as telehealth companies, “medi-spas” and compounding pharmacies have aggressively marketed GLP-1 prescriptions.

We’re only just beginning to learn the full universe of effects for this class of drugs. Originally developed to treat Type 2 diabetes, GLP-1s were soon discovered to be effective in treating obesity and managing weight loss. Now there’s an ever-growing list of other potential uses (on- and off-label), including for treating heart disease, sleep apnea, Alzheimer’s, substance abuse and maybe even gambling addiction. (…)

Spending on GLP-1s is skyrocketing. (…) Perhaps this is unsurprising given that more than 40 percent of Americans are clinically obese. The United States spent an estimated $40 billion on all GLP-1 meds in 2024, with spending projected to triple by 2030.

Consumers are spending less on food and alcohol. The average household with at least one family member on a GLP-1 is spending about 6 percent less on groceries each month within six months of adoption. That translates to about a $416 reduction in food and drink purchases per household a year. Spending reductions are even greater for high-income households, according to a new study by researchers at Cornell University and Numerator.

Other consumer-facing industries are being transformed, too. For example, rapid weight loss has encouraged some patients to replace their wardrobes. The clothing rental company Rent the Runway recently reported that more customers are switching to smaller sizes than at any time in the past 15 years. Airlines could save significant money on fuel if passengers slim down en masse, a financial firm projected. Life insurers could cash in, too, given the many mortality risks linked with chronic obesity.

(…) helping Americans lose weight has the potential to make the public much healthier — and reduce spending on other (costly) care.

Research suggests most patients who were prescribed these meds stop taking them within a year. Some stop because they’ve successfully reached their goal weight. But many others report stopping because of costs, unpleasant side effects, drug shortages or squeamishness about needles.

Obesity-related disabilities, absenteeism, “presenteeism” (that is, showing up but not performing your best), and premature death all have enormous social and economic costs. Which means that making Americans healthier can make the labor market healthier, too, especially if interventions occur while patients are young and have many working years left. (…)

FOMC 101

From Wells Fargo:

• 12 voters, currently 5 hawks, 4 doves, 3 neutral (all chair-related)
• 8 non-voting members who may influence discussions: 4 hawks, 1 dove, 3 neutral.
• 20 total: 9 hawks, 5 doves, 6 neutral.

Gosh! I can’t avoid wondering how the Fed, which could not figure out rentflation and the wealth effect, will be able to grasp how AI and Ozempic will impact the economy.

Wait, no worries, they keep saying they are data dependent, i.e. backward looking…