Interest rates will rise faster and higher than anyone expects
By
MoneyWeek Editor
John Stepek May 31, 2011
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Investors have spent most of the past few weeks holding their breath, watching the squabbling in Europe over who will end up footing the bill for Greece.
But while Europe is certainly a mess, an even more important story is unfolding over in China.
The Shanghai Composite Index has fallen by around 11% since this year's high in April, according to Bloomberg. That's starting to move beyond a 'correction' and towards 'bear market' territory. Chinese stocks managed to claw back some ground today, but only after eight losing sessions in a row.
Why the slide? It's quite simple. Investors are worried that the authorities will continue to tighten monetary conditions.
They're probably right to worry. China's inflation genie has already escaped from the lamp. And that's going to have a major impact on investors all across the globe – perhaps even more so than the final outcome of the euro debacle.
China's inflation is more serious than ever before
Chinese inflation is one of my current obsessions, as you might have noticed. That's because I think it's one of the themes that will have the biggest impact on your investments in the years to come.
Société Générale economist Glenn B Maguire seems to agree. "The course of Chinese inflation… will have a profound effect on the rest of the world." He and his team have looked at four previous bouts of inflation that have hit China over the past 30 years. They conclude that the current bout – the fifth cycle – will prove to be the most significant.
Inflation at 5.3% is currently tame compared to the past. The annual rate hit close to 30% during both the '80s and the '90s. But that's deceptive. Inflation has picked up very rapidly from a low level. Indeed, the inflation rate accelerated at its fastest pace ever during 2010.
More importantly, prior episodes have been cyclical, 'boom and bust' inflations, driven by deregulation and overly loose monetary policy. Money supply has also rocketed this time. But now, inflation looks structural. In other words, it's due to long-term changes in the economy.
For example, China is running low on new, cheap workers. The ratio of labour supply to demand is now higher than at any time in the past. Rather than enjoying a ready supply of new faces from the countryside, cities are being forced to compete with rural areas to attract recruits.
Indeed, rural wages have been rising more rapidly than urban ones since 2004.
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Rising wages mean an improving standard of living for more and more people. "China's marginal worker now appears to be moving through the tipping point of subsistence spending and into discretionary spending." In other words, China is getting to the point where more and more of its people are in the market for 'wants' rather than just 'needs'.
This is great news on a purely humane basis. It means that a larger proportion of people on the planet are getting towards a standard of living that most of us in the West would consider bearable. But the flipside is that it does put more pressure on the world's resources, and that means they become more expensive.
How China will export inflation
How will China tackle this inflation? Tolerating it is one option, but the line between "just enough" and "way too much" inflation is a thin one, and you don't know if you've crossed it until it's too late to go back. Given the social upheaval that inflation could cause, China is more likely to err on the side of caution.
SocGen notes that the big problem with raising interest rates is that it will simply attract even more speculative money. Instead, the best option would be to allow the yuan to float more freely. SocGen expects this to happen in the fourth quarter of this year.
The trouble is, that will export China's inflation across the world, even more than is happening already. As the yuan rises, Chinese exports will get more expensive. There is already a pretty clear link between Chinese inflation and our own. My colleague David Stevenson has charted China's consumer price inflation against Britain's, and the correlation is striking.
Won't production just switch to cheaper countries? That's wishful thinking, says SocGen: "The world will remain a China 'price-taker'… the past two decades of outsourcing that turned China into the world's factory were long-term trends. Manufacturing production cannot simply be transplanted quickly to another economy."
Lead indicators for Britain's economy
What does this mean for investors?
For now, the Bank of England is not going to do much about rising inflation in the UK. Wages over here aren't rising especially rapidly, and that's what the Bank is really worried about.
However, as star hedge fund manager Crispin Odey noted recently, this means that when rate rises do arrive, they'll be much more aggressive than anyone expects.
Odey's point is that this is all part of the grand rebalancing between East and West that needs to happen. Chinese wages go up; ours go down. But eventually that will mean that the East's advantage will be eroded away.
Yes, this adjustment will be painful. But take Ireland as an example, says Odey. If Irish wages are deflating at a rate of 10% a year, while wages in the likes of China are rising by 20% a year, then it's just a matter of time before wages come back into balance. "The only question is, when do emerging markets become uncompetitive with the West and what does that do?"
What will happen, Odey reckons, is that Western labour will come back into demand. As a result, wages will surge, to make up for years of below-inflation wage rises. And that'll force interest rates a lot higher, and far more rapidly than anyone expects. Odey mentions 7%, but doesn't see that as a ceiling. That would be bad news for most stocks, but worse for bonds.
This will take some time to pan out of course – we're talking years rather than months. In the meantime, Odey likes Germany, as an economy that will profit from selling goods to emerging market consumers. But "anything that was built on the arbitrage between cheap emerging markets and rich consumers in the West" will be in trouble: "A frock that cost £180 [last year] will cost £240… how is that going to be squared with the consumer?"
All of this makes sense to us. And while it's impossible to know exactly when rates will take off, the point is that the Bank is going to be stuck behind the inflation curve for quite some time. So get hold of your National Savings & Investment allocation and hang on to gold. Blue-chip stocks with solid dividend pay-outs still look reasonable too – in fact, one of our writers, Stephen Bland, has built a whole investment strategy around them. You can find out more about it here.
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