A weaker yuan could be Beijing’s inflation balm for the world
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Two nations, two inflations
A hungry news market will soon have more data to feed on. Tuesday brings US inflation, which really matters these days, and then a slew of banks will start releasing second quarter results. For a taste of what could be on offer, head to the other leading global economy, China.
Late last week, the People’s Bank of China began what looked like a new round of easing by reducing the amount of money banks were required to keep in reserve when lending. The United States is still dominated by concerns about when and if the Federal Reserve will begin to tighten. There is a reason for this; As the United States braces for core consumer price inflation of up to 4% for the month of June, China had an underlying CPI of just 1%:
This is quite a disjunction for two economies that share the same increasingly discordant global economy. But China has not completely escaped the pressure on prices. While consumer inflation remains under control, producer prices, a measure of the costs paid by companies, are recording their largest increases since the commodity peak that preceded the global financial crisis in 2008. Although two measures often differ, the current gap is the largest of this century:
This implies an unpleasant profit squeeze for Chinese companies. Producers are struggling with a sharp increase in costs, but apparently they do not pass them on to customers. On closer inspection, it appears that cost inflation is confined to large industrial items. A sectoral breakdown of China’s PPI, in the following chart from Commerzbank AG, reveals a minimal problem for consumer goods:
The implication of such low consumer price inflation is worrying. China is expected to move forward as buyers start spending and the economy capitalizes on demand that has remained pent up during the pandemic. It cannot be encouraging. There are big differences between the two major economies, and China hopes to complete the transition from a manufacturing-driven economy to a consumer-driven economy like the United States. But it’s still troubling that consumers are putting so little upward pressure on prices.
For the rest of the world, the most important measure is producer price inflation, which is expected to affect the price at which China sells goods in export markets. The obvious reason for the high PPI is commodity price inflation. The following chart compares the PPI with the Bloomberg Economics China PPI Inflation Tracker, which produces a monthly forecast based on a combination of four commodity price indices. The Bloomberg tracker has been remarkably accurate over the past decade and suffered its biggest overshoot last month:
Why did this happen? China Beige Book International, which produces data on the Chinese economy, says this reflects the authorities’ concerted attempts to eliminate speculative excesses in commodities. According to Shehzad Qazi, managing director of China Beige Book:
Beijing’s latest efforts to cool prices, from threatening speculators to offloading government stocks, have sparked a heated debate over whether the Party can quell the rally. But this fundamentally ignores the political mentality. Rather than trying to sustainably reverse price increases, which reflect the recovery in demand and disruptions in supply chains, the real goal is to chase the speculative “silver ball” out of commodities.
He also suggests that escalating producer prices doesn’t mean China is exporting inflation to the rest of the world – or at least not as badly as one might fear. This graph shows the China Beige Book diffusion indices for the various manufacturing sectors. Metals and chemicals suffer from the worst problems. Consumer electronics and textiles, the main exporting sectors, are also under increasing pressure, but so far are much less problematic. China therefore exports inflation, but not that much:
There is an important reading for currencies. China’s international competitiveness is a function of producer prices and exchange rates. To see how much the exchange rate limits its ability to compete in foreign markets, we need to look at the relative levels of producer price inflation in different countries. Taking into account the PPI, JPMorgan Chase & Co. produces the following index to show China’s overall effective exchange rate, against a range of its major trading partners in real terms. China’s most recent devaluation crisis took place in August 2015, with its wide PPI-weighted exchange rate at more or less exactly the same level as it is now. When it then reached this level in early 2018, it was quickly followed by a drop:
All of this suggests that the yuan may now be as strong as the Chinese authorities can handle. It doesn’t float freely, of course, and its peaks represent tolerance levels among Chinese officials, rather than benchmarks in market psychology. So the chances are that the weight will be on the yuan to weaken from here. This would mean relative strength for the dollar and, at the margin, also lead to lower import prices and lower inflation in the US and Europe.
I warned last month that China could actually export inflation to the United States Judging by the large difference in core inflation rates between the two countries, something like this has happened. But that changes if the latest change in Chinese monetary policy, in response to what appears to be a worrying consumer sector in the country, really means that a weaker yuan is in the cards. Under such circumstances, the prospect is that a source of inflationary pressure for the United States and Europe will diminish. It is in the future. For June, the lingering strange effects of the pandemic on the Chinese economy will have pushed US inflation up. We will soon learn a lot more about the exact extent of the rise in US prices last month.
Pandemics, wages and stock prices
I wrote at the end of last week about research suggesting that past pandemics have led to a strengthening of the bargaining position of workers vis-à-vis capital (even excluding the Black Death and the Spanish Flu of 1918, by far the worst epidemics for which there is good documentation). Real wages rise in the wake of a pandemic.
Tobias Woerner, analyst for Stifel Europe Bank AG, offered further fascinating evidence in this regard. As with all attempts to assess the effects of past epidemics, there simply weren’t enough events comparable to Covid-19 to make statistically valid inferences. We’ll have to settle for some interesting anecdotal evidence. But the way the job market and the stock market reacted the last time around is suggestive.
Using data from eh.net, the Economic History Association’s website (which I highly recommend), Werner produced the following chart of the average US wage ratio to the S&P 500 going back to 1871 (when the S&P backdated calculations begin). When this line increases, the average wage buys more S&P, and when it goes down, it is more difficult to afford stocks with the average wage. Fascinating to see, one of the biggest increases on record occurred in the years immediately following the Spanish flu:
Yes, there were a lot of other things going on at the time; World War I ended, and then the United States suffered a brief but nasty recession, followed by the roaring stock market of the Roaring Twenties. But it’s interesting to see such a sharp shift in this ratio just when it could have been predicted, if pandemics do indeed bolster the work.
Meanwhile, with the major stock indexes setting even more records on Monday as traders awaited their data correction later in the week, it may also be worth noting that the reading at the end of last year was the lowest ever recorded. Over the past 40 years or so, price inflation has been brought under control, but stocks have become much more expensive from the perspective of anyone who hopes to buy them with the proceeds of a normal US wage. It’s worth taking this into account as one of the many signals that an increase in wages, at the expense of shareholders, might not be a bad thing at this point. And thank you again to Woerner for some very interesting research.
For those who need some advice on surviving tough times, you can’t do better right now than reading the words of Marcus Rashford. To the uninitiated, Rashford is a privileged and now very wealthy 23-year-old who plays football for Manchester United and England. He was previously named a Member of the Order of the British Empire, or MBE, for his campaign work to ensure that children who would normally receive free school meals are fed during the pandemic, and has made it clear that his campaign poverty still has “a million kilometers to go” to end child food. He is also Black. And he has the unfortunate distinction of having been the first English player to miss a penalty in the penalty shootout that culminated in Italy winning and England losing in the European Championships final this week. -end.
Since then, Rashford’s social media accounts have been full of racist abuse (as have those of other unsuccessful shooters). A mural of Rashford in his hometown of southern Manchester has been marred by racist graffiti. This is all appalling, and while it represents the actions of a minority hiding behind anonymity, it must be appalling to him. You can find Rashford’s social media post answering all of this here. These are the words of an honest, decent and very courageous young man. He is a remarkable individual who will survive this; and he is an example to all of us.
This column does not necessarily reflect the opinion of the Editorial Board or of Bloomberg LP and its owners.
To contact the editor responsible for this story:
Matthew Brooker at [email protected]