The “China Price”

  • China’s deflation has depressed world prices for over a decade, but now there are signs it’s ending
  • So US inflation may accelerate, making the Fed look too slow in its rate hikes
  • The result could be a global bond market sell-off, temporarily also bad for equities

The resulting global deflationary impact has been one of several dominant influences on central banks, who have developed an almost pathological fear that falling prices will make it impossible to service debt, leading to a new financial crisis. They have responded with an increasingly destructive race among themselves to keep their monetary policy expansionary so as to stop their currencies rising. The result has been ultra-low or negative interest rates, massive bond purchases, and in some cases (eg Switzerland) direct foreign currency intervention. In the US, where economic recovery is more advanced than elsewhere, this competition has taken the form of restricting the rate of rate increases to a glacial pace, the failure to raise rates at this September’s meeting being the latest manifestation of this.

At long last, there are signs that China’s deflation is ending. The producer price index in December last year had fallen to its lowest level since data began twenty years ago, barring a few months around the depths of the financial crisis. But since then, there has been a dramatic change. The index has risen every single month this year, and August’s level stood 5.4% above last December’s. While this partly reflects external factors, notably the currency devaluation and the broad stabilisation of oil and other commodity prices, domestic factors are also at play. Domestic demand has been supported by resumed credit expansion and rising wages. Capacity is being cut in China’s iron and steel sector and while the reductions so far have not met government targets, further cuts should help prices to rise further. Some commentators are sceptical but the message from the data seems clear, not least to the People’s Bank of China, which has ended the policy of monetary ease and exchange rate devaluation that had dominated the last twelve months.

This is globally relevant, and especially important in the US where domestic cost pressures are beginning to grow. US consumer inflation is already rising, the core measure (excluding volatile items like energy) reaching 1.6% on the Fed’s preferred measure (the Consumer Expenditure Deflator) and a heady 2.3% on the Consumer Price Index. Wage growth seems likely to accelerate in coming months, since narrowly-defined unemployment is now close to levels where that has happened in the past, and the broader measure that includes discouraged workers is far below its peak and trending down. The combination of rising wages and the easing of the competitive pressure from China is likely to imply higher US inflation.

This is just what the Fed has been aiming for, but if it does happen over the next few months, just after September’s missed opportunity for raising interest rates from what are still ultra-low, emergency levels, investors may be given a bad impression. It may seem that either the Fed does not really know what is going on, or is consciously acquiescing in a much higher inflation rate than the 2% official target. Either way, a ten-bond yield of around 1.6% (at the time of writing in late September) could seem far too low, and there seems a significant danger of a major sell-off in prices, driving yields much higher.

An added wild card is that the upcoming US Presidential elections may be seen as opening the way to higher government spending on infrastructure and hence higher borrowing, whoever wins, which usually tends to weaken bond prices. And a victory by Donald Trump, which has become a higher likelihood as the gap with Hilary Clinton narrows in the polls, might also be seen as bad news by some bond investors.

If there is a sharp enough bond sell-off, it would probably temporarily damage equity prices, with the likely exception of banks which tend to benefit from higher interest rates. However, such a decline in stock markets would likely represent a buying opportunity, since the improvement in pricing power for global companies as the “China Price” effect fades would probably eventually be seen as more important than the higher discount rate that had to be applied to those earnings due to rising bond yields.

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