The consensus view on Wall Street is that PEOTUS is about to bring $1 trillion in stimulus to the United States – this spending is expected to increase the prices of things, aka inflation; aka Trumpflation. Trumpflation is expected to be benign, gently lifting prices like an old man from a warm bath. But what if its not? What if there was something else lurking that could bring a more sinister type of inflation – the type that eats into profit margins and reduces consumer spending power?
BK is here to tell you that there is something more sinister and it steaming toward the US on a Ultra Large Container Vessel (ULCV).
Factory gate inflation (PPI) is soaring in China – the most recent reading released overnight suggests that the cost of producing in China has climbed by 5.5% on a year over year basis. This is the fastest rise since 2011 and the fourth straight month of increases. If it wasn’t clear already, the era of cheap Chinese production is over.
As you can see from the chart above, Chinese PPI is closely tied to US CPI. This means that the price of things we buy in the US is going up. It also means that companies with supply chains that stretch to China will have to raise prices…if they can.
For some US companies raising prices is unlikely to be a problem, but for others, low priced imported goods are the business model. Let’s take the two most obvious examples, Wal-Mart and Apple. Apple manufactures the iPhone in China via Foxconn – since the cost of doing business in China is rising Foxconn is likely to raise its prices to Apple. Thanks to the cult-like status of the iPhone and the potential for subsidies from mobile phone carriers, the price increase could go unnoticed. But low cost retailers like Wal-Mart face an entirely different challenge. The Wal-Mart business model is to sell low priced goods sourced from China. Promotions like “roll-backs” and price matching are integral to the perception that Wal-Mart is the place to get a deal. Customers are programmed to think that Wal-Mart will always have low prices. But what if that is no longer a valid belief? Wal-Mart (and many of the “dollar stores”) will either need to absorb the prices increases, thus reducing margins, or pass the increase on to customers breaking its implied contract with its patrons. There is no alternative.
On a broader perspective, more expensive imports means that the bond market is probably mispricing the risk of higher inflation. The 5 Year Breakeven inflation rate is pricing about 2% inflation, roughly the same expectation that has prevailed since 2009.
But if the cost of imports are increasing at the fastest pace since 2011 and that increase is expected to be sustained, then the bond market is wrong about 2% inflation. As is typical, BK is early on this view. There are others talking about it, but not enough for it to have an immediate impact on securities prices today. That being said, rising inflation (the bad kind) is one of BK’s themes for 2017.