Andy Xie: The Rise of the Inflation Nations

Andy Xie, our renowned Chinese economist shared his insights on the Chinese economy – The Rise of the Inflation Nations in his recent article at Caixin (below is the extract):
The common denominator linking China, the United States, Japan and European countries is they will all grapple with inflation, and hedging is no simple task

Bubbles Form

The increased lag between money and inflation creates opportunities for speculation. Even though the global economy is in a poor shape, excitement could occur in some pockets. Prices in these pockets can skyrocket, as these pockets are small relative to the overall global money supply. In the past five years, we have seen many such bubbles come and go. Chateau Lafite, Chinese antiques, postmodern paintings, and puer tea are just a few examples. Many such bubbles are still standing.

As mentioned before, the prices of Manhattan properties are surging again. The financial crisis hurt the middle class most. The rich could still respond to low interest rates. Hence, the properties where the rich congregate appreciate with QE, while middle class properties sink in response to weak employment.

Despite a bad global economy, there is a big bubble in the stock market, not across the board, but in stocks with strong growth. Internet stocks have valuation similar to that during the last bubble in 1999-2000. Global consumer companies with mega capitalization value are trading at historically high valuation.

The biggest bubble is in government bonds. The interest rates on U.S. treasuries, for example, are half of the average inflation rate of the past five decades. German and Japanese bonds are in the same camp. Government bonds have total nominal value over US$ 50 trillion. When inflation expectation finally takes hold, the crash of this market may create another financial crisis.

Inflation Hedging

One must consider the base effect and supply-demand balance for inflation hedging. I often receive questions on why property prices shouldn’t continue to rise with inflation. The difference is in the past. When the price of a certain commodity or asset has risen multiple times, it will decline even when inflation comes.

Let’s say that inflation in the future would double the general price level in a decade. Any commodity or asset that has seen its price more than doubled already may not be a good inflation hedge. The bubble phenomenon has made many commodities and assets bad inflation hedges.

Supply expansion decreases the attractiveness of an asset for inflation hedging. High prices due to bubbles have increased supplies in many assets and commodities. Their prices could underperform general inflation. I want to give China’s property and iron ore sectors as examples.

The land price in China has appreciated probably 30 times in the past decade, 100 times in some hot spots. Even though the general price level is likely to more than double in a decade, the price of land still has a long way to fall just to be in line with the overall price level. Further, the supply has expanded so much relative to population that its price relative to wages should fall too. Even though inflation is coming, Chinese property isn’t a good inflation hedge.

The price of iron ore peaked at about eight times the average price in the 1990s. The current price is five times. While the price performance is similar to oil, its fundamentals are much worse. The looming supply increase is 7.5 million tons per annum, more than China’s total imports. China’s steel consumption is declining. The total demand is likely to be stagnant in the decade to come, as the country’s property and infrastructure investments have peaked. The supply increase will make iron ore the worst performer in the commodity space. I suspect that the price of ore will decline by 50 percent from the current level.

Oil performs better than iron ore because its supply isn’t rising significantly. Unlike steel, oil can’t be recycled. Hence, its supply and demand balance is more favorable to its price. In the commodity space, the stocks of oil companies could be good inflation hedges.

Because most assets good for inflation hedging are already inflated, one may have to adopt a dynamic hedging strategy. Inflation is a process. Paper money erodes gradually in value. Holding onto cash is still good for now. When inflation is recognized, government bonds will drop in price to reflect inflation in future, one can switch cash into bonds then. This strategy is probably the best for most people. Waiting will bring a payoff.

Contact us today to engage Andy to share his insights at your next conference.