Zhang Yu: Three Core Agenda Items——Zhang Yu Decadal Conference Minutes No.135

Why does the Fed closely monitor medium- and long-term inflation expectations and oil prices?

Hello, investment friends. In this cycle, I focus on three main topics: First, the increasing tail risk in U.S. monetary policy—we summarize this as “be more or not to be,” meaning the Fed’s policy path now has hardly any moderate options; it’s either a significant rate cut, a pause, or even a rate hike. Second, the assessment and differences of domestic and international stagflation risks. Third, the midstream manufacturing sector, which we’ve emphasized for months; I will mainly discuss how macro judgments are translated into investment choices.

1. The Increasing Tail Risk in U.S. Monetary Policy: “Be More” or “Not to Be”

Regarding U.S. monetary policy, we first want to clarify a core judgment: the market’s expectations for rate cuts reflected in FedWatch are highly linked to oil price fluctuations. In other words, if short-term geopolitical developments in Iran and oil prices cannot be predicted, it’s difficult to accurately gauge changes in rate cut expectations. Based on this, our current core framework is to observe U.S. medium- and long-term inflation expectations (specifically, focus on the 5-year 5-year USD inflation swap rate and the 10-year breakeven inflation rate). Medium- and long-term inflation expectations are the key anchor for the Fed’s monetary policy, which directly determines that the current policy path has no room for moderation.

We consider two scenarios:

Scenario 1: High oil prices + stable medium- and long-term inflation expectations → larger rate cuts (“Be More”). The reason is that, for the Fed, as long as inflation expectations do not show a clear upward trend, the target for medium- and long-term interest rates remains unchanged. The additional demand-side losses caused by oil price fluctuations need to be offset by rate cuts, and the higher and more prolonged oil prices are, the greater the impact on consumers’ living costs and spending, requiring larger rate cuts. For example, during the U.S. tariff increases in April 2025, even if tariffs cause inflation volatility, the medium- and long-term inflation expectations among residents remain stable. In this scenario, the current tightening trades driven by oil price fluctuations will be later offset by larger-scale easing trades.

Scenario 2: High oil prices + trending upward medium- and long-term inflation expectations → pause or even rate hikes (“Not to Be”). Although the Fed aims to control inflation and stabilize employment, the risk of inflation expectations becoming unanchored outweighs the risk of employment decline. If high oil prices persist and drive medium- and long-term inflation expectations upward, it means the Fed’s rate cut cycle will be fully ended, with a risk of rate hikes. Under this scenario, the current tightening trades are justified, and it will be difficult to see a strong easing reversal later.

In summary, the key difference between these two scenarios lies in the alignment between market trading magnitude and changes in medium- and long-term inflation expectations. If they diverge significantly, a reversal trade may occur; if they align closely, the current trend will continue. This is our most important macro framework for judging the Fed’s policy direction—closely monitoring changes in medium- and long-term inflation expectations in the U.S.

2. Assessment of Domestic and International Stagflation Risks: Overseas Risks Significantly Higher than Domestic

Our core view is that global stagflation risk is much higher than China’s domestic stagflation risk, mainly due to the significant differences in the economic cycle positions domestically and internationally.

From a domestic perspective, after three to four years of real estate transformation and deep economic adjustments, China’s PPI and CPI year-over-year have remained in the low range for three years. From a cyclical standpoint, it’s difficult to form a stagflation environment. Specifically:

ØRegarding “stagnation,” the room for further economic slowdown is very limited. We see that, excluding five subsidy-related commodities and one real estate chain commodity, the remaining retail sales (mainly essential consumption) have stabilized since late 2024. This indicates that, after multiple shocks such as the pandemic and real estate adjustments, core economic variables have formed a stable base, making a sharp downturn unlikely.

ØRegarding “inflation,” upward pressure on inflation is generally manageable. We summarized the triggers for rate hikes over the past 20 years as “236”: when core CPI YoY exceeds 2%, CPI YoY exceeds 3%, or PPI YoY exceeds 6%, two of these conditions being met typically prompts the central bank to raise rates. Even under optimistic stress tests—assuming oil prices rise to $100/barrel, pork prices increase, durable goods prices grow at the same month-on-month rate as last year, and service sector prices remain high—CPI YoY for the year would likely stay below 3%, with PPI at 5-6% and an annual median around 2-3%. Overall, inflation remains moderate and unlikely to trigger stagflation.

Internationally, the economic cycle position is highly similar to China in late 2021. Over the past two years, many countries have preemptively cut rates, keeping their economic data in a relatively strong state, with prices already high. Any geopolitical conflicts that push up costs could easily lead to stagflation, similar to China’s situation in late 2021, consistent with the evolution of the economic cycle per the Merrill Lynch clock.

Overall, although inflation perceptions vary across sectors and categories, macroeconomic cycle analysis suggests that overseas stagflation risk is much higher than domestically, and the probability of systemic stagflation in China remains low.

3. The Midstream Manufacturing Sector: Four Macro Top-Down Stock Selection Criteria

In recent months, we have continued to emphasize the midstream manufacturing theme, based on the following core logic:

ØFirst, demand side: Global supply chain security concerns have created demand resonances independent of the economic cycle. The demand for key intermediate and capital goods related to supply chain security, national defense, and technological backup is largely unaffected by global economic fluctuations, driven by security needs, and exhibits independent prosperity.

ØSecond, supply side: Domestic efforts to reduce internal competition (“internal involution”) have optimized and integrated supply. Meanwhile, high oil prices and geopolitical instability in Iran, Venezuela, and other regions have accelerated the clearing of weaker capacity in the global supply chain, especially those less competitive than China. Domestic reforms and high oil prices abroad have benefited leading firms, aligning with China’s role as a major exporter of intermediate and capital goods.

ØTherefore, the overall dispersal of demand and the ongoing concentration of supply will continue to drive Chinese exporters of intermediate and capital goods to achieve global premium pricing and market share gains. This is the core logic behind our optimism for the midstream manufacturing sector.

Based on this logic, from a macro top-down perspective, we propose four stock selection criteria. Note that these are not the only standards; strategy and industry research will consider additional factors. But from a macro view, meeting at least three of these four criteria indicates high research value:

ØFirst, high overseas revenue exposure. Currently, overseas export prosperity and growth are significantly higher than domestic consumption growth. Stocks with high overseas revenue are better positioned to benefit from export cycles.

ØSecond, excellent industry structure. The best scenario is high industry concentration (few dominant players) and dispersed downstream demand. Such firms can better capitalize on supply-demand shifts.

ØThird, strong pricing power. This can be demonstrated by either: (1) the ability to produce similar products globally at lower cost, giving China firms a cost advantage; or (2) possessing irreplaceable technology and capacity barriers that prevent overseas competitors from mass-producing certain products. Only with pricing power can firms pass on cost changes and maintain profitability.

ØFourth, high industry barriers created by heavy capital investment (“HALO”). High barriers further strengthen competitive advantages.

These are our overall macro insights on the current three major topics:

1. The increasing tail risk in U.S. monetary policy—almost no moderate options left, only bigger rate cuts or pauses/hikes, closely watching medium- and long-term inflation expectations.

2. The difference in stagflation risks—overseas risks are much higher than domestic.

3. The midstream manufacturing stock selection criteria—meeting three of four standards offers good investment opportunities.

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