Happy New Year! I hope you had a great Christmas.
China delivered a slightly unusual Christmas present for the markets this year: an interest rate hike.
It was just a little one. Nothing to rattle the horses too badly. And it hasn’t stopped the bull market in commodities – copper has continued to hit record highs, for example.
But it’s a warning of what’s likely to be one of the biggest themes of the year – how the rest of the world will cope as China goes into inflation-fighting mode…
Every nation has a ‘flation bogeyman. For the US, and most developed countries (with the notable exception of Germany), the big worry is deflation. The memory of the 1930s Depression and more recently, Japan’s never-ending stagnation, has given the West a chronic fear of falling prices. High levels of debt – deflation is bad news for debtors – don’t help, of course.
As a result, monetary policy in these countries tends to be biased towards inflation. Right now in particular, the UK and the US would be very happy to tolerate a fairly high level of inflation in the hope of getting rid of some of their debts the easy way.
But not every country is worried about deflation. For others, the biggest fear by far is inflation. And they’ll do what it takes to stop it. Germany for example, is reluctant to encourage a weak euro, even although it does well out of the single currency being fragile.
Why China is scared of inflation
And another inflation-phobic country is China. It’s easy to see why. Inflation is a bigger problem in developing countries than developed countries for a few simple reasons. A far larger chunk of most people’s incomes goes on things we would regard as basic necessities, such as food. So rising inflation makes life particularly painful for people near or at the bottom of the earnings scale.
Most of these people don’t carry a lot of debt – they can’t afford to. So they don’t see inflation as a painless way of eroding their mortgage. They see it as something that threatens to push them to the brink of starvation. When you combine this with the existence of a growing middle class, and an increasingly obvious wealth gap between the rich and the poor, you have a recipe for social upheaval.
As Yu Song of Goldman Sachs pointed out in The Telegraph a couple of days ago: “Ever since I was a kid I was told that one of the reasons the Communists came to power was because the previous Nationalist government had caused hyperinflation.” High inflation was also a major factor behind the Tiananmen Square uprisings. So you can see why the Chinese premier Wen Jiabao has vowed to crack down on rising prices. The quarter point rate hike to 5.81% was just the latest in a line of moves to do so.
What will happen now Chinese economic growth is slowing?
The Chinese economy’s growth is already easing up somewhat. The latest manufacturing survey for December showed that the sector’s rate of expansion slowed for the first time in five months.
But what does it mean for the rest of us? Well, the main question is – can China slow its economy without having a hard landing? People have been predicting a slump for China for years now, and so far it hasn’t happened. And it may not happen now.
The best-case scenario is that China can tweak things enough so that it manages to slow down without crashing. The problem is, walking the tightrope between tightening “too much” and “not enough” is never easy.
China’s most obvious impact has been on the commodity markets. These are still surging, with many predicting $100 oil and more record prices for copper in the year ahead. We’re happy with the idea that demand for commodities in general has been pushed higher by the growing strength of the east.
But at these levels, commodities look vulnerable to any disappointments. If investors get the jitters about demand from China, then prices are likely to fall back. And if China’s economy really slumps, then chances are we’ll see a rush back to the dollar and a panic that could drive down asset prices across the world.
However, if commodity prices keep moving higher, inflation is increasingly likely to cause problems on this side of the world too. Inflation in the UK is already well above target, and it’s expected to remain so for the foreseeable future. If we don’t see signs of it coming down then the Bank of England will be under increasing pressure to start raising rates.
Where to put your money
With so much dependent on just what policymakers in China, Europe and elsewhere in the world decide to do, it’s impossible to say exactly what will prove the biggest threat. That’s why for now, we’re sticking with our broad view of backing gold, defensive stocks and Japan. Gold provides a hedge against currency depreciation, defensive stocks can stand up to both inflation and economic weakness, and Japan – it’s cheap and Henry Maxey of Ruffer provides a sound rationale for buying it: Steer clear of emerging market stocks.
The global economy may well muddle through – but there are likely to be plenty of surprises and opportunities up ahead. For more specific plays, our experts give their views on the best tips for 2011 in the next issue of MoneyWeek magazine. If you’re not already a subscriber, subscribe to MoneyWeek magazine.
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