February 15, 2021
With a rational government in place, moving policy forward, the world can turn to real issues that don’t involve babysitting world leaders. Or so it would seem.
Here is a brief review of some of the interesting things going on in the world, that some may have missed because there is a LOT of confusion and concern due to a really, really wide variety of world activity.
- Russia has placed sanctions on the Ukraine and is telling the EU they will cut ties if the EU retaliates with sanctions against Russia. If you are not following that story, Russia has been bullying the Ukraine for decades and even annexed part of the country (Crimea) in 2014. The idea that Putin is anything but a dictator intent on dominating Europe is ridiculous on its face.
2. Italy finally has a government. Prior to COVID, this blog highlighted a few of the many, many difficulties facing Italy, and since then the government has been in constant turmoil. While it would be reasonable to blame the politicians, the reality is that things are so bad in Italy, that any leader will have tremendous difficulty stabilizing the country’s financial system and political dysfunction. This past week Mario Draghi (who saved the Euro currency from collapse as head of the ECB) was sworn in as Prime Minister of Italy. Failure remains an option, but this is better than another populist government.
3. COVID-19 is still a thing. When measuring a pandemic, regulatory actions are important, but viruses don’t really care about beliefs or feelings or politics. Viruses propagate. But since the election of Joe Biden, and perhaps due to changes in policy, perhaps an acknowledgement by many in the US that caution is warranted, perhaps testing issues, perhaps some related to the virus itself, COVID cases are declining in the worst affected country in the world (~25% of reported cases, 6% of the world population). Along with the ramp up of vaccines, the health effects of COVID should start to decline as the year progresses but variants may continue to make this a big deal for years and years to come.
4. Bitcoin is undergoing a renaissance, as it gets adopted by Tesla. This got those roving bands of pretend capitalists all worked into a frenzy, and this frenzy may be less likely to stop. The idea that a completely made up digital currency, backed by nobody, with no meaningful baseline value, huge volatility and nearly impossible to use for transactions should somehow become a method of transacting business is bizarre. But here we are.
5. Meanwhile the earth is showing no mercy, with an arctic deepfreeze affecting much of the world, and meaningful earthquakes shaking Japan.
There is so much more, but this post is about scary stuff, not world leaders intent on taking over continents or money becoming worthless, or the earth throwing us off in an attempt to save itself. This post is about China’s main export.
If you’re thinking electrical machinery (#1) and computer equipment (#2) or kitsch plastic bits at a dollar store (#4) or perhaps iron and steel (#8) I would argue that you are wrong. China’s primary export for the past twenty years has been deflation. Here is a chart of US inflation since 1993. The struggle to raise inflation in the rest of the world has been overwhelming, resulting in inflation of just 2.1% on average, with returns since 2008 struggling to get over 1.5% even with support from central banks around the world.
When trade between China and the US began in earnest just before the turn of the century, the average wage was rising rapidly from about 6,200 CNY (about $800 USD) in 1996 to about 30,000 CNY (about $4,000 USD) in 2008. If you think this through and imagine all of the issues faced by G7 economies now, you might see a causal relationship. Let me detail some considerations:
- Companies moved production of goods and even some services to China. This allowed them to save on labour costs, regulatory burden (environmental, employment, etc.) and even taxation.
- Jobs for working class families literally disappeared overnight. Factories shut, replaced by lower wage service jobs, and higher wage intellectual roles (logistics, engineering, marketing and sales come to mind)
- Intellectual property was placed inside the borders of a foreign country where control was hard to maintain
- Investment dollars poured into G7 countries, taking over housing, industries and other areas.
These are just some of the outcomes that can be easily identified. This list isn’t meant to demonize the outcomes, although that is certainly possible. It’s just a list of things that were bound to happen and they did.
But it didn’t stop there. After the collapse of markets in 2008, the US government injected about $2 trillion of borrowed money over four years (keep this number in mind) to support markets, and China helped by buying large swaths of commodities, companies and promising to increase the speed at which they develop a consumer based economy. (Again, the importance of that statement is critical. For a couple of decades their primary focus was to work their people to the bone to create wealth for the country. People saved their money and the country didn’t promote consumption, fun, etc.)
The effect of all of this, to repeat was to export deflation. The heads of central banks worked really, really hard to increase inflation (to mitigate the negative effects of rising debt loads), and all of their policy maneuvers weren’t working.
Now as the COVID response drags on, far, far longer than expected, the key economies of the world have deployed over $11 trillion to save economies, in less than 1 year. (Remember, $2 trillion in the US over four years for the 2008/2009 ‘Great Recession’, they are at $7 trillion plus in the last year alone.) But still there isn’t significant inflation. This post isn’t about why this money hasn’t increased inflation. It is about why inflation is coming.
After the 2008 collapse, China has not slowed down their industrial economy, they have not slowed their intellectual progress, they have promoted fun and consumption, as promised, but just on the surface. They have unleashed ever further control over resources and production capacity around the world. To keep all of that going, they also have worked very hard to improve the living standards for their new army of intellectual and working class people (the same cannot be said for agricultural workers and other ‘less productive’ people, particularly from outlying regions).
At the end of 2019, the average wage in China had reached about 93,000 CNY (about US$15,000) per year and while that doesn’t seem like a lot, it is over 1,000% higher (ten times higher) than it was 20 years earlier. For reference, the US minimum wage was $5.15 in 1997, it rose to $7.25 in 2009 and remains there now. In the US, the median income in 1997 was $18,000, in 2019 it was about $34,000 or about 88% higher according the US Bureau of Labor Statistics.
So what of their main export? By making their goods and services available to people around the world at far lower wage rates and lower overall costs (environmental, regulatory, etc.), China quickly and effectively raised their economic prowess to match the rest of the world in many measures. It is likely that China will be the largest economy in the world, if not now, within the next two years.
There is a very good chance that will lead to their greatest export becoming inflation.
As labour costs rise to match the rest of the world it will no longer be exporting lower prices. Soon China’s consumption of raw materials, including food, fuel, metals and ideas, not to mention the services related to them will begin to overwhelm the world’s supply of these items.
To help with some numbers, the EU has about 1.4 billion people, about 18% of the population and about 40% of the population of the ‘developed’* world.
If you follow commodities, the impact of this transition is beginning to take shape. Like anything else, there are many contributing factors, but as ALL assets run up, there are important breaks from expectation that may be setting up for long term breakouts.
The following four charts highlight some of those breaks. (1) Interest rates; (2) oil; (3) copper; (4) wheat. It would be reasonable to include the decline in the dollar as well, but the relationships there are broadly different, so that is excluded for another time.
Interest Rates have been rising. The chart below shows the 10-year US treasury. With a rate close to 1.2% (12.00), it is up sharply from 0.5% during the early days of the COVID outbreak, but still below the 1.5% floor (now ceiling, to use charting lingo) that held between 2012 and 2019. If it breaks that level, debt costs will increase dramatically and the stock market is likely to encounter tremendous difficulty.
Oil is the most heavily traded commodity in the world and investment made during the past two decades unleashed a massive wave of oil at low prices, however many of the companies drilling for oil failed to make a profit, or failed to recover enough to meet the costs of their business. The declining price of oil between 2008 and 2020 was a key reason why inflation remained muted. That run is now (almost certainly) over and oil is returning to a level where it can be found, processed and sold at a profit. The lower bound of that level is likely around $60-70 a barrel. It currently sits just about $60. Here is a monthly chart for West Texas Intermediate Crude (US Oil)
Copper is used very heavily in modern economies, and a spate of heavy investment just before the 2008 Great Recession followed by the massive injection of liquidity resulted in excessive capacity in the world of copper for many years. The need to rebuild the electrical grid (Green energy, Electrical vehicles and more) are causing significant and in some cases, new levels, of demand for the metal. Meanwhile investment has been stagnant because the price of copper is too low to justify searching for new resources. The price of copper is now rising quickly in anticipation of higher demand as well as higher inflation. The monthly chart is below.
Wheat is just one of many soft commodities that are showing a similar pattern. A basic necessity for food around the world, wheat is rising in price as it attracts funds, in expectation of both inflation and future demand. Other food items have risen even faster where supply issues are arising.
As China’s wages, consumer demand and production prowess increase, there is a high probability that they will no longer be exporting deflation, rather they will be fighting for the same resources that other countries need causing increases in inflation.
Owning commodities like those listed here will offer protection from that inflation, as well as other hard assets like homes/land and long lived hard goods.
This blog has questioned the inflation/deflation outcome for some time, and while there is still some uncertainty about the outcome, some of the arguments for inflation are beginning to line up, and some inflation protection may be wise.
* A value of 75 on the Human Development Index was selected as the cutoff for ‘developed world’. Interestingly this excludes India, the second largest country by population, but to make sure this omission wasn’t way off base, a comparison of GDP per capita was examined as well (which is a completely different measure, but still a meaningful comparison). The last country included based on the Human Development Index was Peru. India – $2,003; Peru – $6,230; China – $11,710; United States – $66,140