Inflation and the Asian Factor

On October 29, 2014, Federal Reserve Bank policy statement indicated that near term inflation should remain constrained by falling energy prices and other factors. Good news for shoppers and borrowers as interest rates are not likely to rise dramatically anytime soon. How does that play into investment scenarios?

Inflation measured by personal-consumption expenditures rose at an annualized rate of 1.4% in September, below the Fed target of 2%. Interest rates remain low with the benchmark yield on 10-year Treasury paper at 2.335%. A 15-year fixed-rate mortgage clocks in at 3.21%.

On October 31st, Wall Street traders took their eye off of Ebola-ravaged West Africa and shifted attention to Asia as a massive Japanese stimulus program revived animal spirits, lifting global stock markets. The S&P 500 Index and the Dow Jones Industrial Average, bouncing off of an early fall swoon, closed at record highs.

With both the European and Japanese central banks pushing easy money stimulus policies as the U.S. Fed phases out our stimulus program known as quantitative easing, global money is flowing into the U.S. seeking better returns. The U.S. dollar has appreciated substantially against the yen and the euro, as well as other currencies. Since our dollar buys more, imports cost less in dollar-adjusted terms. Good news for lovers of imported French, Italian, and Spanish wines and tourists headed abroad on holidays. The Fed likes a strong dollar up to a point as it restrains inflation. Investors have to watch a potential “race to the bottom” as other countries devalue their currencies to make their exports more attractive and imports from America less compelling.

Where is China in the outlook for inflation? California-based Brandes Investment Partners searches the world for stock values and a September report on China is instructive. China has been on a tear building infrastructure—roads, railways, airports, real estate. Brandes notes that China used more cement in the last three years than the U.S. consumed in the entire 20th century. Since 2004 economies that produce basic materials such as coal, copper, iron ore, nickel, and aluminum have benefited from Chinese growth as China is a net importer of basic commodities. Australia has been a prime beneficiary as have countries in Africa.

Brandes indicates that for the past 10 years China’s economic growth was propelled by investments in fixed capital, i.e., manufacturing capacity, residential and commercial real estate, and infrastructure. This has resulted in excessive investment, debt expansion, and overcapacity in some sectors. A correction in soaring property prices is expected.

As China moves away from a fixed-capital intensive growth model to something more balanced such as encouraging more in-country production and consumer buying, we would expect subdued pressure on commodity prices, another factor in restrained inflation. The Dow Jones Commodity Index ended October down 9.03% year-to-date. Gold is touted as an inflation hedge. The gold exchange traded fund (ETF), the SPDR Gold Trust, GLD, is down 15.7% from its 52-week high. Silver has more industrial uses than gold. The silver ETF, iShares Silver Trust, SLV, is down 28.6% from its 52-week high.

The China story continues to fascinate as money managers search for growth stories. China is now the world’s largest auto market. Brandes notes that German-based BMW sold 20% of its vehicles in China in 2013, more than any other country. Per USA Today (7/7/14), General Motors sold 1.7 million vehicles in China in the first half of 2014 compared to 1.46 million sold in the U.S. Ford’s China sales rose 35% to 549,256 vehicles in the same period. Yet China suffers from overcrowded roads, big city congestion, and extreme air pollution problems at times, offering both challenges and openings for opportunistic companies.

The ongoing battle between yin and yang continues. U.S. GDP growth at a 3.5% annualized clip in the 3rd quarter cheered investors and attracted global capital flows. With low interest rates likely to continue investors have to balance risk and reward in seeking investments that will grow in excess of inflation and taxation. Volatility and risk must be examined carefully in crafting investment strategies. Fortune cookies are fun but are not to be relied on as predictors!

Lewis Walker is President of Walker Capital Management, LLC. Certain advisory services offered through The Strategic Financial Alliance, Inc. (SFA). Lewis Walker is a registered representative of SFA which is otherwise unaffiliated with Walker Capital Management, LLC. lewisw@theinvestmentcoach.com

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