Chinese Inflation Will Scare Investors More, Then Temper Demand

China's artificially low currency and domestic price control program is one of the world's largest "imbalances." (Of course, it goes hand-in-glove with excessive American credit and borrowing.) Now the world is waking up to those imbalances more than ever, which means securities market volatility remain high while the resolution is pending but uncertain.

Specifically, we see increasing risk of more acute Chinese inflation fear in newspaper headlines, and subsequently some demand moderation in China as the normal function of higher prices finally kicks in. This outlook contributes to our (1) unwillingness to fully re-balance our underweight equities allocation until we see more evidence of "crisis" on some Developing Markets, and (2) unwillingness to go overweight energy now, believing that they're becoming more vulnerable to the global slowdown that's unfolding.

To elaborate, we'll offer a few snippets from Professor Michael Pettis' blog in the past two days. Shortages as a result of price controls are becoming more acute, such that prices will have to rise, which should ultimately lead to a "demand response." This process has been taking far too long, but it may accelerate. From Pettis' post today:

• I had lunch with a senior banker from a major Chinese bank today. He is based in Shenzhen, across the border from Hong Kong in the southern province of Guangdong. Among other things he told me that lines at gasoline stations are getting terrible, in part because a lot of Hong Kong residents drive to the mainland to fill their gas tanks. Gasoline on the mainland is at less than the half global price, so this isn’t much of a surprise. He also told me that he thinks actual inflation is higher than the headline CPI number. That isn’t a big surprise either, I guess.

  Finally we discussed concerns about a coal shortage, and I read in today’s Xinhua a confirming article that claims that coal reserves have fallen to a 12-day supply, which I think I understand from the Xinhua article is a record low level, even less than March’s already-worrisome 15-day supply. The combination of low coal reserves and gasoline shortages means, I think, that it is going to be hard to keep a lid on energy prices. I wouldn’t be surprised to see energy prices, which are controlled in China, rise in the next few weeks, even amid all the worry about spreading inflation.

And from yesterday's post:

• I noted two other interesting pieces today. Xinhua reports that the authorities are announcing new measures to crack down on “profiteers.” They say:

  China’s oil regulators are ready to launch a nationwide crackdown on wholesalers who sell to illegal filling stations and dealers in the wake of supply shortages…

  …Illegal dealers and filling stations are believed to have aggravated the situation by hoarding oil and jacking up prices to drivers wanting to avoid the long queues at licensed stations.

  Aside from the obvious point that shortages are a common consequence of price controls, it is clear that an inflation purist would insist that the long queues, from which people are willing to pay money to escape, are a form of reduction in the quality of good or service that is as much a component of inflation as higher prices, and so headline inflation is being disguised as waiting time. Real inflation is higher than the official numbers, and Chinese motorists are paying this higher cost, but it is not showing up correctly in CPI.