More Inflation Scares Ahead
Andy Xie (Hong Kong)
Summary and Investment Conclusion
The monetary bubble that the Fed has created post-tech burst has created property and commodity inflation (mainly in food and oil). I anticipate the cost-push inflation will spread to general inflation in the coming months, which may shake the bond market.
I believe the global economy is headed toward either mild deflation or stagflation. If central banks cut interest rates in 2005 in response to slowing growth — an outcome of the oil shock — the global economy may be headed toward stagflation. If central banks focus on price stability and, hence, do not cut interest rate in 2005 despite slowing growth, the global economy could be headed toward low growth and low inflation with deflation in certain periods and some sectors.
Beneath Greenspan's magic wand: cheap Chinese labor
The US import price from Asian newly industrialized countries (or NICs) has declined relative to its general import price by 3.5 percentage points per annum and by 5.2 percentage points relative to the US CPI.
The concentration of IT goods in Asian exports is a big part of the story; the US import price for IT products has declined by 60% in the past ten years. The US prices for consumer products have roughly remained constant since 1993 compared to a 31% rise in the US CPI.
The decline in the prices of IT products is not entirely a product issue. The production of consumer goods was rationalized earlier, with the bulk of production relocated to China from higher labor-cost economies ten years ago. The production of IT goods has been relocating to China. The availability of Chinese labor has been a major factor in allowing US IT import prices to decline by 8% per annum.
China has become the first source of supply in the global economy, especially for the US. The elasticity of US imports from China to the US retail sales appear to range between 4-5 in the past ten years.
The US retail sales ex-auto rose by $1 trillion between 1993-2003, and the imports from China by $120 billion. As Chinese products are sold at 3-4 times the import costs, the Chinese imports may have accounted for one-third to one-half of the increase in the US non-auto retail sales.
The nominal wages at the export factories in Pearl and Yangtze River Deltas that account for three-quarters of China's exports have roughly remained constant for the past ten years, mainly due to the influx of migrant workers from inland provinces. This has allowed China's supply curve to remain horizontal during a demand surge.
A horizontal supply curve magnifies the powers of central banks, as the inflationary consequences of monetary policies are absent. What a central bank says becomes very important in such an environment. If it can make market participants optimistic, the monetary stimulus leads to rising asset markets that increase demand subsequently to validate the optimism.
The productivity gains have allowed China's supply curve to shift outward over time, especially through relocation of the production of IT products from high-wage economies to China. This has created a constant downward pressure in the prices of manufacturing goods.
This deflationary pressure has allowed the Fed to create so much liquidity that the ratio of the US money with zero maturity to GDP is 50% above the average in the past three decades. This is why the ratio of the stock-market capitalization to GDP or property price to wage is so much higher than the historical norms.
Rising food and energy prices signal a different game
I believed in deflation (see 'A Look at Pricing Power', October 21, 2002).
The case was built on a massive positive shock to the global labor supply, as technologies allowed Chinese and Indian labor to integrate into the global economy much quicker than before. The declining elasticity of labor demand to GDP in mature economies is the best proof of the new paradigm.
Rising prices of food and oil may have signaled a new era. They may have become the new bottlenecks in the global economy, replacing labor.
Certainly, the prices of food and oil would also be cyclical. The point is that the big cushions from the spare capacity in food and oil supplies may have been exhausted during the furious growth since 1998 stimulated by the loose Fed monetary policy. The cushions made the prices of these essential inputs insensitive to monetary stimulus.
Without the cushions, the prices of these two inputs would flare up quickly in response to monetary stimulus, which decreases the potency of monetary stimulus and makes its inflationary impact immediate.
The linkage between food and oil to Chinese wages makes the Chinese supply curve not horizontal anymore during the US monetary stimulus. Some argue that the food inflation in China is temporary. I think otherwise.
China's grain production peaked in 1998 and has been declining ever since. The combined total of rice, wheat and corn declined from 441 million tons in 1998 to 363 in 2003. The food prices were kept down by the release of inventories.
The rapid industrialization of Yangtze River Delta ('YRD'), which is a grain basket for China, has big impact on China's grain production. The land prices in the region have risen so much due to industrialization and urbanization that it would make economics deteriorate overtime for grain production. When the monetary condition in the US loosens up, it increases the speed of industrialization in YRD and, hence, food prices.
China's consumption, on the other hand, would continue to grow, as the meat consumption-a less efficient diet increases with income growth. As China's production is unlikely to top the last peak in 1998 while consumption would rise above the previous peak, the food prices are on a secular upturn, in my view.
Oil could be another long-term problem. Cyclically, oil prices could come down sharply in 2005, if China has a major correction (see 'A Major Correction Ahead', September 20, 2004). The change in oil is the depletion of overcapacity with OPEC. Oil prices were low as OPEC lost its market share, as it tried to defend prices around $25/barrel, while countries with higher production costs took advantage of the prices to increase production.
Even though proven global oil reserves are still at 42 years of current consumption as in the past, the production of the non-OPEC countries appears to have peaked out. Most reserves that could be bought to the market are in Middle East. It seems that, with non-OPEC countries maxed out, the OPEC can defend higher oil prices. Also, the political and security environment is not good for increasing supply soon. Without a cushion of excess capacity, oil prices would be higher and more volatile than in the past. When monetary policy stimulates demand, oil prices could spike up quickly.
Another inflation scare may be coming
Inflation in most economies is still restricted to food and energy. Financial markets do not expect inflation to spread beyond food and energy. The yield on US treasuries, for example, is negatively correlated with oil price at present; the market seems to believe that a rising oil price slows down the US economy and makes the Fed less likely to tighten and is not worried about the inflationary impact of rising oil prices.
I believe the complacency in the market may be misplaced. I see two reasons why inflation could spread beyond food and energy. First, the relocation of IT production to China may be coming to an end. The cost savings from the relocation have pushed the US import prices down but could be running out. This could signal the end of the downward trend in the US import prices for goods from Asia.
Korea and Taiwan's export prices have been rising since the middle of 2003. This is the longest period of their export prices rising. Higher fuel and steel prices and semiconductor cycle may have contributed to this trend. I suspect that diminishing scope for cost rationalization may be an important factor.
Second, the erosion of real wages for Chinese factory workers is causing a supply backlash. Food and energy account for a large share of the expenditures of the factory workers in China. The reduction of their real wages is so severe that migrant workers are unwilling to move to the coast.
China's export sector has managed to meet demand despite labor shortage, which is due to spare capacities in the system. The spare capacities would be exhausted. As time goes on, even the existing workers may decide to leave, as they could not save enough from their wages to send home. The way out, I suspect, is that the export factories in China would have to raise wages to attract sufficient migrant workers. That would mean that the US import prices for Chinese goods have to rise, which has a big impact on the US retail prices.
Is it stagflation or deflation beyond the boom?
In my view, the current global boom is another monetary bubble. It will burst. When it does, would the global economy face stagflation or deflation?
China is over-investing massively in most of its industries. When the investment bubble bursts, the capacity overhang would cause deflation as occurred between 1996-99. However, oil and food prices were low and falling last time. The balance between overcapacity and oil and food prices would determine if the global economy would feel deflationary or stagflationary.
The key to the outcome is how long the monetary bubble lasts and, hence, how high oil and food prices go. The longer the bubble lasts, the higher the oil and food prices would go, and the more likely the outcome is stagflationary. Even though oil and food prices would come down when the bubble bursts, their inflationary impact takes time to work into general prices.
Where oil prices peak out, therefore, would be a key to a stagflationary outcome. The bond market now appears to believe that higher oil prices are good for bonds, because it makes central banks less likely to raise interest rates. When high prices are high enough to cause a stagflationary outcome, the relationship between bonds and oil would reverse.
Andy Xie (Hong Kong)
Summary and Investment Conclusion
The monetary bubble that the Fed has created post-tech burst has created property and commodity inflation (mainly in food and oil). I anticipate the cost-push inflation will spread to general inflation in the coming months, which may shake the bond market.
I believe the global economy is headed toward either mild deflation or stagflation. If central banks cut interest rates in 2005 in response to slowing growth — an outcome of the oil shock — the global economy may be headed toward stagflation. If central banks focus on price stability and, hence, do not cut interest rate in 2005 despite slowing growth, the global economy could be headed toward low growth and low inflation with deflation in certain periods and some sectors.
Beneath Greenspan's magic wand: cheap Chinese labor
The US import price from Asian newly industrialized countries (or NICs) has declined relative to its general import price by 3.5 percentage points per annum and by 5.2 percentage points relative to the US CPI.
The concentration of IT goods in Asian exports is a big part of the story; the US import price for IT products has declined by 60% in the past ten years. The US prices for consumer products have roughly remained constant since 1993 compared to a 31% rise in the US CPI.
The decline in the prices of IT products is not entirely a product issue. The production of consumer goods was rationalized earlier, with the bulk of production relocated to China from higher labor-cost economies ten years ago. The production of IT goods has been relocating to China. The availability of Chinese labor has been a major factor in allowing US IT import prices to decline by 8% per annum.
China has become the first source of supply in the global economy, especially for the US. The elasticity of US imports from China to the US retail sales appear to range between 4-5 in the past ten years.
The US retail sales ex-auto rose by $1 trillion between 1993-2003, and the imports from China by $120 billion. As Chinese products are sold at 3-4 times the import costs, the Chinese imports may have accounted for one-third to one-half of the increase in the US non-auto retail sales.
The nominal wages at the export factories in Pearl and Yangtze River Deltas that account for three-quarters of China's exports have roughly remained constant for the past ten years, mainly due to the influx of migrant workers from inland provinces. This has allowed China's supply curve to remain horizontal during a demand surge.
A horizontal supply curve magnifies the powers of central banks, as the inflationary consequences of monetary policies are absent. What a central bank says becomes very important in such an environment. If it can make market participants optimistic, the monetary stimulus leads to rising asset markets that increase demand subsequently to validate the optimism.
The productivity gains have allowed China's supply curve to shift outward over time, especially through relocation of the production of IT products from high-wage economies to China. This has created a constant downward pressure in the prices of manufacturing goods.
This deflationary pressure has allowed the Fed to create so much liquidity that the ratio of the US money with zero maturity to GDP is 50% above the average in the past three decades. This is why the ratio of the stock-market capitalization to GDP or property price to wage is so much higher than the historical norms.
Rising food and energy prices signal a different game
I believed in deflation (see 'A Look at Pricing Power', October 21, 2002).
The case was built on a massive positive shock to the global labor supply, as technologies allowed Chinese and Indian labor to integrate into the global economy much quicker than before. The declining elasticity of labor demand to GDP in mature economies is the best proof of the new paradigm.
Rising prices of food and oil may have signaled a new era. They may have become the new bottlenecks in the global economy, replacing labor.
Certainly, the prices of food and oil would also be cyclical. The point is that the big cushions from the spare capacity in food and oil supplies may have been exhausted during the furious growth since 1998 stimulated by the loose Fed monetary policy. The cushions made the prices of these essential inputs insensitive to monetary stimulus.
Without the cushions, the prices of these two inputs would flare up quickly in response to monetary stimulus, which decreases the potency of monetary stimulus and makes its inflationary impact immediate.
The linkage between food and oil to Chinese wages makes the Chinese supply curve not horizontal anymore during the US monetary stimulus. Some argue that the food inflation in China is temporary. I think otherwise.
China's grain production peaked in 1998 and has been declining ever since. The combined total of rice, wheat and corn declined from 441 million tons in 1998 to 363 in 2003. The food prices were kept down by the release of inventories.
The rapid industrialization of Yangtze River Delta ('YRD'), which is a grain basket for China, has big impact on China's grain production. The land prices in the region have risen so much due to industrialization and urbanization that it would make economics deteriorate overtime for grain production. When the monetary condition in the US loosens up, it increases the speed of industrialization in YRD and, hence, food prices.
China's consumption, on the other hand, would continue to grow, as the meat consumption-a less efficient diet increases with income growth. As China's production is unlikely to top the last peak in 1998 while consumption would rise above the previous peak, the food prices are on a secular upturn, in my view.
Oil could be another long-term problem. Cyclically, oil prices could come down sharply in 2005, if China has a major correction (see 'A Major Correction Ahead', September 20, 2004). The change in oil is the depletion of overcapacity with OPEC. Oil prices were low as OPEC lost its market share, as it tried to defend prices around $25/barrel, while countries with higher production costs took advantage of the prices to increase production.
Even though proven global oil reserves are still at 42 years of current consumption as in the past, the production of the non-OPEC countries appears to have peaked out. Most reserves that could be bought to the market are in Middle East. It seems that, with non-OPEC countries maxed out, the OPEC can defend higher oil prices. Also, the political and security environment is not good for increasing supply soon. Without a cushion of excess capacity, oil prices would be higher and more volatile than in the past. When monetary policy stimulates demand, oil prices could spike up quickly.
Another inflation scare may be coming
Inflation in most economies is still restricted to food and energy. Financial markets do not expect inflation to spread beyond food and energy. The yield on US treasuries, for example, is negatively correlated with oil price at present; the market seems to believe that a rising oil price slows down the US economy and makes the Fed less likely to tighten and is not worried about the inflationary impact of rising oil prices.
I believe the complacency in the market may be misplaced. I see two reasons why inflation could spread beyond food and energy. First, the relocation of IT production to China may be coming to an end. The cost savings from the relocation have pushed the US import prices down but could be running out. This could signal the end of the downward trend in the US import prices for goods from Asia.
Korea and Taiwan's export prices have been rising since the middle of 2003. This is the longest period of their export prices rising. Higher fuel and steel prices and semiconductor cycle may have contributed to this trend. I suspect that diminishing scope for cost rationalization may be an important factor.
Second, the erosion of real wages for Chinese factory workers is causing a supply backlash. Food and energy account for a large share of the expenditures of the factory workers in China. The reduction of their real wages is so severe that migrant workers are unwilling to move to the coast.
China's export sector has managed to meet demand despite labor shortage, which is due to spare capacities in the system. The spare capacities would be exhausted. As time goes on, even the existing workers may decide to leave, as they could not save enough from their wages to send home. The way out, I suspect, is that the export factories in China would have to raise wages to attract sufficient migrant workers. That would mean that the US import prices for Chinese goods have to rise, which has a big impact on the US retail prices.
Is it stagflation or deflation beyond the boom?
In my view, the current global boom is another monetary bubble. It will burst. When it does, would the global economy face stagflation or deflation?
China is over-investing massively in most of its industries. When the investment bubble bursts, the capacity overhang would cause deflation as occurred between 1996-99. However, oil and food prices were low and falling last time. The balance between overcapacity and oil and food prices would determine if the global economy would feel deflationary or stagflationary.
The key to the outcome is how long the monetary bubble lasts and, hence, how high oil and food prices go. The longer the bubble lasts, the higher the oil and food prices would go, and the more likely the outcome is stagflationary. Even though oil and food prices would come down when the bubble bursts, their inflationary impact takes time to work into general prices.
Where oil prices peak out, therefore, would be a key to a stagflationary outcome. The bond market now appears to believe that higher oil prices are good for bonds, because it makes central banks less likely to raise interest rates. When high prices are high enough to cause a stagflationary outcome, the relationship between bonds and oil would reverse.
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