Chinese inflation was 4.9% in January 2011. A significant portion of the CPI increase was due to rising food prices.
Photo Credit: StockVault.net
-- This is a guest post by Jay Pelosky, Principal, J2Z Advisory, LLC --
I recently attended a very interesting roundtable on China’s future growth path, led by The New America think tank and the World Policy Institute.
While listening to the debate over China’s need/ability to change its economic model, it struck me that the catalyst for such change could be developing right before our eyes – namely, inflation.
To twist a phrase, inflation is NOT always and everywhere, a bad thing. Today’s investment climate suggests that inflation would be welcome in Japan, large parts of the EU and even the good old USA. Yet, inflation today exists largely in the EMs – that could well become a very good thing.
Here’s why. China and EMs more broadly face an inflationary environment (inflation is breaching 8% in some nations) driven by surging food and fuel prices. These components make up 40-50% + of many EMs CPI baskets and as such, threaten social stability as we have already witnessed in the Middle East. Yet, rapidly rising prices/social stability risk may be just the lever needed to convince EM policy makers that currency appreciation is the best tool to tackle this threat. FX appreciation stands in sharp contrast to the other main policy weapon , rapidly raising domestic interest rates; this is especially true in China, where such a policy course could quickly turn the vast amounts of credit provided over the past few years into NPLs.
Such a change in course by EM policy makers would be a very good thing for EM nations. It would bolster domestic demand, facilitate the economic model shift, enhance social stability, be a statesmen like act, reduce trade friction and foster the essential task of rebalancing global demand, a boon to both East and West. Needless to say, it would also support the US equity recommendation that is the central investment theme of my globalization of demand thesis.
There is however, the other edge of the inflationary sword to consider. In this less benign scenario, EM Govts refuse to let their FX appreciate and instead plump for the interest rate weapon to attack inflationary pressures. Such a decision would run the risk of inciting a hard landing in China and elsewhere in the EMs, threatening the only real source of sustainable end demand in the world economy. To extend this scenario a bit, one could consider a sharp slowdown in global demand as a result of such EM decision making, most likely manifesting itself in late 2011 and into 2012. Such an economic environment could foster growing investor fears of OECD policy maker impotence , as fiscal decision makers fight the last war and rush to cut spending while monetary authorities cower under withering criticism, be it the Fed, the BOE, BOJ or even the soon to be rudderless ECB.
While this less benign scenario is worth pondering it is not my base case. China holds the key as it is the price setter for most of the world’s production. A tidbit gleaned from the roundtable may help assess its likely future path; of the nine seats on the Standing Committee of the Chinese Politburo (China’s top decision making body) five seats are held by the military and like militaries the world over, the PLA likes stability. In addition, the news this week that China has put forth a growth target of 7% for 2011-15 suggests such a model shift may well already be under way. Time, of course, will tell.
In a nutshell, EM inflationary pressure bears very close watching over the next six months. The response to such is more important than the cause. The response will either reinforce or call into question the globalization of demand theme which is my central investment scenario for the next several years. In the US, rising oil prices are more of a tax on consumption than an inflationary threat. As such, rising energy prices may enhance the odds of QE3 rather than lead to higher interest rates, suggesting that the prospects for a bond market rally are coming into view. On the equity front, I continue to think we are in the early phase of a healthy correction, most likely taking the S&P down to the 1250 level. I would be a buyer of such a correction, though watching carefully the EM inflation fighting policy evolution. I continue to favor US equity over EM equity and EM USD debt over EM local currency debt.