Transition in Japanese Economic Landscape and Expectations of Rate Hikes

Our Global Chief Economist and Global Cross-Asset Strategist discuss the state of the global economy at the midpoint of 2024, including how the U.S. and Europe are on growth trajectories despite volatile economic data.

----- Transcript -----

Serena Tang: Welcome to Thoughts on the Market. I'm Serena Tang, Morgan Stanley's chief global cross-asset strategist.

Seth Carpenter: And I’m Seth Carpenter. Morgan Stanley's global chief economist.

Serena Tang: And on this two-part episode of the podcast, we'll discuss Morgan Stanley's global mid-year outlook. Today we'll focus on economics, and tomorrow we'll turn our attention to strategy.

It's Monday, May 20th, at 10am in New York.

So, Seth, we've seen a lot of volatile economic data since you published your 2024 year ahead outlook last November. The US has gone through a few months of downside inflation and upside growth surprises, followed by renewed inflationary pressures; and in China, real growth surprise to the upside, but deflation deepened. In contrast, India and Japan, your two strongest conviction bullish views, have played out so far.

So, with all this in mind, Seth, what is your outlook for the global economy and its growth trajectory for the second half of this year and into 2025?

Seth Carpenter: So, we're pretty optimistic. We see some mild deceleration in the US relative to last year's particularly strong growth but not collapsing. And I think that part is really important. The euro area growth, all the signs that we've had since we wrote the outlook in November, updating now it says that growth is actually bottomed out there and we're starting to see the initial recovery. Now, don't get carried away. It's not that it's gonna be this massive rebound. But there should be now a bottoming out gradual growth as inflation keeps coming down. That means that real wage growth is actually going to get stronger, and we think consumption starts to lead the way.

China though, there we've surprised the upside but just an inflation adjusted growth because fiscal policy has been adding to capacity they're adding to the ability. And so, deflation has stayed. It's one of the longest and deepest deflationary episodes China has had. We think that's actually going to be exporting deflation to the rest of the world. But in terms of real growth, they're actually hanging in there around 5 per cent.

Serena Tang: I'm glad you kind of highlighted the difference between what we're expecting for the US and Europe and what we're expecting for China, because one of the themes that I think you touched on in this outlook is divergence that you see some slowing in the US -- even though it's very stable, while the rest of the world really is where growth starts to pick up. 

So, what is driving this divergence? How persistent do you think it will be? And what does it mean for central bank policy?

Seth Carpenter: Let me start with Europe and the US, the way you framed it. Like I said, European growth is probably bottom. They had more adverse shocks than the US did. So, the energy shock -- that was particularly damaging to German manufacturing, really slowed the European economy down. Whereas in the US, we had a lot of strong growth last year. Last year we had growth in the US at just over three per cent. Non-trivial amount of that growth was enabled by the surge of immigration, but we still see some residual impetus from fiscal policy.

And so, where are we now? Inflation in the euro area is continuing to fall. In fact, it's clearer signal down than it has been, at least for the fourth quarter this year in the US. Growth is picking up, but not so much that it's going to re-spark inflation. So, we think the ECB is going to start to cut rates as soon as next month, as soon as the June meeting. Whereas for the US, we still have strong growth. Inflation sort of gave us that head fake in the first quarter, so the Fed's going to have to wait, we think probably until September.

Serena Tang: And on the point of inflation, can you actually give us a snapshot of where we are right now and what your projections from here will be? You know, you talked about disinflation in the US. What's gonna be driving that?

Seth Carpenter: I think the first thing to keep in mind is that just globally we see further disinflation and so the run up in inflation that was, by and large, a global phenomenon, we do see as abating. For the US specifically, though, I think there are a few parts that are really important and always the conversation has to deal with housing. 

There, in the United States, we measure housing inflation through rents, and we know various things. One recent readings on rents in the market right now have actually been moving roughly sideways. The statistical agency, the Bureau of Labor Statistics, that creates the CPI, takes those market-based rents and then spreads it through an algorithm. And the official statistics reflect what's going on now over the next couple of quarters. So, for that reason alone, we think rent inflation, which is 40 per cent of core CPI, we think that keeps trending down over the rest of the year.

We see some deflation in consumer goods. That's especially in automobiles. The deflation that we see in China, that's probably being exported to the rest of the world, contributes a little bit more to that downward pressure. So, we feel pretty convicted that the high inflation that we saw in the first quarter was more noise than signal, and we get greater disinflation as the year goes on.

Serena Tang: So finally, I want to ask you about Japan specifically. It's the region where we're actually expecting rate hikes. Since it has gone through a structural shift recently, decades of deflation are now over, seems to be over. And so, what are your expectations there?

Seth Carpenter: I think it is a fundamental shift here. We did have decades of essentially zero nominal growth and that is now clearly, in the rear-view mirror. We see wage inflation; we see price inflation. When I talk to our colleagues in research in Tokyo who cover the consumer sector, the mindset has shifted, and consumers are willing to accept these higher inflation prints.

And so, in that regard, we do think very much we've shifted from that zero nominal growth, that sort of disinflationary-deflationary equilibrium, to one where inflation will be sustained above target. As a result, the Bank of Japan got rid of negative interest rate policy. And we think they're gonna hike into positive territory in July of this year. Probably again in the beginning of next year.

All, as long as we're right, that inflation is here to stay and that seems very much the case. Now, why only two rate hikes then as opposed to more if the world is fundamentally different? And this, I think, is critical. Governor Ueda, the BOJ, is committed to making sure that we have shifted to this reflationary environment. And so, I do think he's going to be cautious and only hike as much as he can be confident that inflation stays high for the foreseeable future.

Serena Tang: Seth, thanks so much for taking the time to talk.

Seth Carpenter: Serena, it's always great to talk to you.

Serena Tang: And thanks for listening. Please be sure to tune in for Part Two of this episode, where Seth and I will discuss our mid-year strategy outlook. If you enjoy Thoughts on the Market, please leave us a review wherever you listen, and share the podcast with a friend or colleague today.