Slow economic growth, accelerating inflation

Andrew Vaughan - Wed 30 Aug, 2006

...Slowing growth, accelerating inflation - these are the two major fears of investors today...

 
 
- Slowing growth, accelerating inflation - these are the two major fears of investors today. It is in the markets’ nature to see ghosts where none exist. But that does not make the panic these spooks cause any less real.

- Apart from knee-jerk reactions to fresh troubles in the Middle East, however - plus security fears in the UK and US - global markets have lacked direction over the last month. August always marks the "silly season", when traders go on holiday and deal-making slows.

- But during this year's lull, evidence is piling up from around the world that slowing growth and accelerating inflation are, rather than mere ghosts, a dawning reality.

- I was in Singapore earlier this month. There, on the day that record GDP growth figures for China were released, I found myself listening to predictions that Chinese growth could slump from the current 10% level to 4% in 2007. The reason? Forceful measures from the Chinese government to cool excessive growth, plus recession in the US.

- At the seminar, Dr Jim Walker, the well-regarded commentator at CLSA, went on to spell-out the negative impact of surging labour costs in China and of slowing growth on the newly-privatised banks there. Add-in a drop in demand for Chinese goods from the US, and we have the makings of a major slow-down.

- Will it happen? At some stage, I don't doubt it. 10% is not a sustainable growth figure in a developing country that faces infrastructure bottlenecks, rocketing input costs, government intervention in the market place, and a rickety banking system. There are pot holes in China's road to growth, and they are going to hit investors’ shock absorbers hard from time to time.

- However, I am sufficiently convinced that China’s industrialisation is structural and long-term, rather than cyclical and temporary. I therefore believe you want exposure to China for the long-term, regardless of what next quarter’s GDP growth figure may be.

- It would be wrong to look at China in a vacuum, as recent economic figures from Australia underlined. Here, while the economy as a whole has been growing at mid-single-digit rates, the State of Western Australia’s growth rate has been matching that of China at nearer to 10%. The reason of course is Western Australia’s mining industry and its export trade with China.

- The strength of house prices and consumer spending in Western Australia’s capital city, Perth, have become more dependent on continuing growth in China than in the Australian economy as a whole. Just like the Eurozone, however, Australia must contend with a single interest rate across its disparate regional economies.

- In the UK, the US and Europe, our inter-dependence with China is becoming more evident in both inflation and growth figures. Cheap imported goods from China helped bring inflation down. Now, with manufacturing cost inflation rampant in China and its export markets firmly established, China is breathing inflation into its trading partners. Its timing could hardly be worse.

- Wholesale gas prices in the UK have already risen by over 70% in 2006. Drought has reduced the harvests of major wheat producers around the world, pushing food prices higher. In Australia, Consumer Price Inflation (CPI) has breached the central bank limit of 4%. In the UK, the Bank of England governor has warned that official inflation could now exceed 3%. That failure would require a written explanation to the Chancellor of the Exchequer.

- The response of central banks to rising inflation? With the notable exception of the US, which kept interest rates on hold this month for the first time in two years, interest rates are also rising.

- To us, this response seems bizarre. It was not falling interest rates, but imported price deflation from China, that kept CPI figures benign against a backdrop of strong growth. Low inflation was an imported, rather than home-spun, phenomenon. To use domestic interest rates now to counter external price pressures shows questionable economic logic.

- Rising interest rates in fact have more to do with giving central banks fresh ammunition to deal with a future slow-down. They had precious little firepower when US dollar interest rates were only 1%. Now the Federal Reserve has moved to 5.25%, so it has scope to cut the cost of borrowing once again.

- But Ben Bernanke’s address to the US Congress on 19th July seemed confused. He voiced an expectation that inflation would retreat from recent highs. He also referred to guarding against costly future "inflation surprises". So which is it?

- This is no backdrop for a broad equity market advance. However, in an inflationary environment, cash is no place to be either. That's why "real asset" investments for your portfolio are a good idea, assets whose value should survive the rigours of inflation - such as gold, real estate and alternative investments such as wine.


Regards,

Andrew Vaughan
for The Daily Reckoning