Chinese stocks surge, concerns about US inflation grow

We’re more than halfway through the first quarter, and it seems that clients have more questions by the day as the news flow intensifies. The rise in Chinese stocks, concerns about US inflation, and the direction of 10-year US Treasury yields are among the things we’ll be watching as we head into the back half of the first quarter — and beyond.

Chinese equities 

Chinese stocks have been on a tear this year, continuing their strong performance that began later in 2024.¹ Year-to-date as of Feb. 14, the MSCI China Index has risen 13.9%, dramatically outperforming the MSCI USA Index’s 4.4% gain.²

One initial catalyst for last year’s rally was significant stimulus from Chinese policymakers. In recent weeks, the rally was largely driven by excitement around DeepSeek’s artificial intelligence (AI) advances. My colleague Raymond Ma has argued that various benefits brought by DeepSeek — higher efficiency, cost savings, stronger computing power and a much lower barrier for various industries to use AI — could benefit many Chinese companies and cause a re-rating of Chinese stocks. I couldn’t agree more.

And it’s not just DeepSeek. It’s also companies such as BYD, which has caused a paradigm shift for electric vehicles. Chinese companies are moving up the value-added chain and offering very competitive products in some industries. Chinese stocks have had attractive valuations for years, but the appearance of these important catalysts has made the difference. Chinese stocks, especially Chinese tech stocks, could have a long runway, in my view.

US Inflation expectations

There is growing concern about a resurgence in US inflation. One way to gauge that risk is through inflation expectations. There are two kinds: survey-based and market-based.

Survey-based

There are several different surveys that capture what consumers expect in terms of future inflation. This is important because the Federal Reserve (Fed) pays attention to these surveys and has been known to act on them. As I’ve previously noted, there has been a large jump in consumer inflation expectations in the University of Michigan Survey of Consumers. We haven’t seen as big a jump in the New York Fed Survey of Consumer Expectations, which showed that consumer inflation expectations for January were unchanged at 3.0% for the one-year ahead and three-year ahead periods.³ However, inflation expectations for five-years ahead rose by 0.3 percentage points to 3.0%, which is material. Ditto for Conference Board consumer inflation expectations. For one year ahead, they rose from 5.1% in December to 5.3% in January.⁴

Consumer inflation expectations are particularly important because they can become a self-fulfilling prophecy. If a consumer expects prices to go up enough in the next year, they are likely to purchase an item now, thereby helping to drive up the price of the item because of increased demand for it.

Market-based

One key indicator is the spread between yields for Treasury Inflation-Protected Securities (TIPS) and Treasuries of the same maturity, which is called the breakeven rate of inflation. Five-year breakeven inflation has risen significantly in the last several months, from 1.86% on Sept. 6, 2024 (just as US President Donald Trump began climbing in the polls) to 2.62% on Friday.⁵

We will want to pay close attention to market inflation expectations and consumer inflation expectations because they matter to the Fed. In June 2022, for example, the Fed signaled in advance of the Federal Open Market Committee meeting that it would likely hike rates by 50 basis points, and then it surprised markets by hiking rates 75 basis points. When asked in the press conference what had altered the Fed’s course, Chair Jay Powell said a few recent data points had changed the Fed’s mind, including the Consumer Price Index and University of Michigan inflation expectations. So, especially as some investors worry that the Fed will stay on pause this year — or even hike rates — it’s important for us to pay attention to inflation expectations for clues about what is to come.

The 10-year US Treasury yield

The 10-year US Treasury yield has been the focus of a lot of interest this year, with many wondering if it will rise to the psychologically disturbing 5% level. Interest in it has only risen since US Treasury Secretary Scott Bessent indicated that the Trump administration will focus on bringing down the 10-year yield rather than trying to push the Fed to cut rates on the short end. In the last week, Trump seemed to suggest a similar sentiment, posting “Interest Rates should be lowered, something which would go hand in hand with upcoming Tariffs!!! Lets Rock and Roll, America!!!”⁶

As I’ve said before, I don’t believe the 10-year US Treasury yield will climb much higher — unless there is a resurgence in inflation or concerns about the fiscal deficit grow and bond vigilantism takes hold. This of course will depend on the Trump administration’s policy agenda and execution. There has definitely been a focus on cost cutting, but it is dramatically different than the Simpson-Bowles Commission’s approach. Thus far investors seem to be comfortable with the current strategy, although I am seeing some skepticism about how much money will truly be saved. We could also see heightened nervousness about fiscal spending when the spotlight falls on attempts to raise the debt ceiling by $4 trillion.

Having said that, my base case is that the 10-year yield won’t pierce 5% this year, although I do think we will see some volatility in the yield given increased uncertainty. I do think there could be periods where concern over fiscal deficits moves the yield higher, but not dramatically higher. We want to follow the 10-year Treasury yield closely because historically it has had a significant impact on stocks, with higher valuation stocks typically coming under pressure when the 10-year US Treasury yield has risen.                                                                                  

Cracks in the US economy

A recession is certainly not my base case for 2025. However, we have said since the Fed began its aggressive tightening cycle that we need to look carefully for signs that the tightening has materially damaged the US economy. Thus far it hasn’t happened. However, mass layoffs of federal workers have begun, and some high-profile companies have announced substantial layoffs. This could be a significant problem for the economy given that Fed Chair Powell already flagged low job growth as a concern if layoffs were to increase.

We will want to follow the situation closely, especially as consumer sentiment has declined recently. I think it’s important to note several findings from the most recent NY Fed Survey of Consumers. First of all, median household spending growth expectations declined to the lowest level since January 2021. And the survey showed the mean perceived probability of losing one’s job in the next 12 months increased by 2.3 percentage points to 14.2% in January.⁷

The price of gold

Gold has rallied year-to-date, hitting new highs.⁸ This is the continuation of a longer-term rally and has been fueled by several different drivers. Geopolitical uncertainty — driven by concerns about a tariff war created by the US — has driven demand for gold’s “safe-haven” qualities. Other demand drivers include concerns about excessive fiscal spending in the US, price-insensitive central bank buying, and more vehicles for investors to purchase gold. In the US, Costco began selling physical gold bars to customers in 2023; Wells Fargo estimated in April 2024 that Costco was selling up to $200 million in gold bars each month. ⁹ A new gold ETF launched in India recently, and Chinese authorities are now permitting insurance companies to invest in gold.

Of course, gold prices could ease if central banks start purchasing less and/or a peace deal in Ukraine comes to fruition. But from my perspective, the direction of travel for the price of gold is most likely up given that the European Union would likely feel threatened and perceptions of geopolitical risk could even rise as a result of any peace deal negotiated exclusively between the US and Russia.

The direction of the stock market

I’ve had a number of clients marvel at the intestinal fortitude of stock market investors, who have overlooked all the tumult going on in the US and continue to send stocks higher. They whisper, “When is the stock market finally going to become unhinged and sell off?”

The answer is: We don’t know. The stock market has a way of ignoring risks and then suddenly reacting to them in a rather dramatic way — we’ve seen this before when it comes to high valuations.  However, for those with a long time horizon, this is rather irrelevant — it’s all about staying the course. And in fact, the AAII Bull/Bear Sentiment reading, generally viewed as a contrarian indicator, suggests a US stock rally could gain momentum. Bearish sentiment has risen from 29.4% right after the US presidential inauguration to 47.3% last week. Bearish sentiment is unusually high, well above its historical average of 31.0%.¹⁰ Bearish sentiment was last higher on Nov. 2, 2023, at a whopping 50.3%.¹⁰ Interestingly, late October 2023 saw the start of a strong stock market rally.¹¹

Pair-wise correlations

We have seen a significant decrease in pair-wise correlations for the S&P 500 Index. Pair-wise correlations are a measure of how closely correlated individual stocks within an index are to each other; in other words, it indicates how much stocks move in tandem with each other.

Generally, higher pair-wise correlations suggest less opportunity for stock picking. Conversely, a decrease in pair-wise correlations suggests that it may be a good time to be a stock picker. As Standard & Poor’s noted, “Correlations within and across equity markets continued near historical lows and the associated diversification effects have played a significant part in dampening both realized and implied index volatility.”¹² This suggests active management will be increasingly important.

Looking ahead

This coming week, we will still be getting earnings. We will also get the FOMC meeting minutes from January and a few central bank decisions. I will also be interested in seeing the University of Michigan Survey, which comes out this Friday.