Importing Inflation

As the rich West flags, emerging economies are already suffering stronger inflation...

INFLATION HAWKS have been warning since 2008 that the spurt of US money creation that began at the end of that year would spark a surge in consumer-price inflation, writes Martin Hutchinson at Money Morning.

And yet the consumer price index (CPI) statistics remain quiet – not giving ammunition to the deflationary camp, but making "inflationists" look silly, as well.

Now, however, it is becoming obvious that inflation will soon arrive. But this time it is sneaking in through the back door – courtesy of our emerging-market trading partners. Fortunately, there are some very clear steps that investors can take to protect themselves from this expected inflationary surge.

If you want to see inflation in action, you can see it most clearly in China. Officially, inflation in China in the year to April was only 2.8%. However, China's inflation statistics understate the truth even more seriously than most emerging-market nations.

For one thing, gathering data in such a huge country is very difficult. You can see that the Chinese people think inflation is much higher than that from the wage rises being demanded.

Foxconn International Holdings – the Taiwan-based licensed maker of practically all the electronic gadgetry made by Apple Inc., Sony Inc., Microsoft Corp. and others – raised the wages of all its Mainland China workers a full 30% after 10 workers killed themselves and another three attempted suicide at its 300,000-employee Shenzhen factory this year. Wages will increase an additional 66% in October for workers meeting performance standards.

On the other hand, a Honda Motor Co. Ltd. operation in Southern China was shuttered Monday after workers walked off the job having rejected a 24% wage increase (they want a 75% increase, and other benefits, too). In a research note written this week, Macquarie Group Ltd. analyst Chia-Lin Lu said that such labor-cost increases are "an unstoppable trend".

And it's not just wages. Urban real estate prices are up 13% in the past year. But real-estate costs are not properly included in China's inflation calculations.

Although China's productivity is rising, it's not doing so quickly enough to absorb wage increases in the 20% to 30% range (let alone in the ultra-high-rent 66% to 75% neighborhood). Therefore, prices of Chinese goods – everything from video games to sweatshirts – are likely to rise in Dollar terms. That will happen whether or not China revalues the Renminbi (the official term for its currency, also known as the Yuan).

Another indication that China's competitiveness has declined: After years of huge surpluses, the Asian giant ran a payments deficit in April. But China isn't the only one facing this challenge. The other three "BRIC" economies – Brazil, Russia and India – all have significant inflation.

Russia, with 6% inflation, is the least important of these to the US economy, since its exports are primarily commodities whose prices are determined by world markets, rather than by the domestic economy.

Brazil's inflation rate is 5.4%, and that country's central bank is worried enough about its acceleration that it has raised the Selic short-term rate to 9.75% – a punishing level.

Finally, India's inflation situation looks to be pretty well out of control, at 14.5% on a consumer price basis. Given that country's huge budget deficit and difficult balance-of-payments situation, it appears to be nearing crisis. Several other major emerging-market economies also have double-digit inflation, such as Turkey, Egypt, Pakistan and Argentina (where the figures are fudged). In Venezuela, even official figures say inflation is already 30%.

The troubling level of emerging-market inflation is not surprising. Around the world, countries have been frantically engaging in fiscal and monetary "stimulus" with huge budget deficits and negative real interest rates. That has caused commodities prices to soar and emerging-market economies, the ones enjoying real growth, to see that growth accompanied by substantial-and-rising inflation.

Even in Britain – where some of the recessionary sting has been offset by a weakening in the exchange rate – inflation is now up to 3.7%. That's well above the official Bank of England (BOE) target of 2%. Only in the stagnant economies of the United States, the Eurozone and Japan – three markets where recession has been deep and recovery very sluggish – has inflation not yet taken off.

In the downturn, the rich-but-sluggish economies have seen yet more production outsourced to the rapidly growing economies with lower labor costs. That's caused unemployment rates to soar. The good news for those economies is that the inflation in emerging markets will soon help them out of this dilemma. Emerging-market production will become more expensive, both bringing inflation to the rich sluggards and pricing some of their work forces back into jobs. Real wages will decline – but through the comfortable effect of price rises and wage stagnation rather than through outright cuts. Prolonged "stagflation" will be pretty unpleasant for the rich countries' citizens – but it beats a prolonged slump.

To understand why it's time to position yourself for the onset of inflation, it's important to first understand how this forecast will play out. In "rich" economies such as the United States, the current low inflation rates are due to the exceptionally deep recession.

As emerging-market economies experience higher rates of inflation - while also continuing to grow rapidly - the commodities and manufactured goods they are exporting to those rich countries will rise in price. That will enable rich-country manufacturers to better compete, since their own wares will become cheaper on a relative basis.

But the imports on which the rich nations too intently depend will rise in price. Thus, inflation will return to the "rich" countries – via the poor ones.

For investors, the continued erosion of purchasing power will be difficult to deal with. Companies such as Caterpillar Inc., the Boeing Co. and Deere & Co. – that have been able to export throughout the recession – will find their margins fattening and their export volumes buoyant. All three are worth a closer look in my opinion.

However, the best investments will likely be those traditional inflation hedges: Treasury Inflation-Protected Securities (TIPS), but especially gold. As inflation returns and currencies face difficulties through their budget deficits, gold will come to be seen as the only reliable store of value, by central banks and retail investors alike. And that means higher Gold Prices lay ahead.

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