Factory gate inflation in China has increased to a four year high – before you doze off at this seemingly unimportant fact consider that China is the factory to the world – which means rising prices at the factories in China means higher prices at your local Wal-Mart. The days of cheap labor and low manufacturing costs are over – the last time Chinese factory gate inflation climbed to this level was during 2010. Way back then the world was recovering from a deflationary shock and the Chinese government and companies had the borrowing ability to absorb rising prices without passing them onto US consumers.
China is About to Export Inflation – PPI
But since then, Chinese debt to GDP has exploded from 125% to 250%, rivaling Japan for the world’s most indebted nation. Why does this matter? Because lower profit margins and little ability to borrow to cover rising prices means the costs must be passed through the supply chain. And at the end of that supply chain is the American consumer.
IBKHO, the market is completely mis-pricing this inflation narrative. Sure break-even inflation rates have picked themselves up off the floor, but they have yet to break out of the narrow range that has existed since 2009.
5 Year Inflation Break-even Rate
As higher prices in China filter through the supply chain it is quite possible that inflation in the US rises more rapidly than the market expects. This inflation “shock” could be enough of a catalyst for gold to resume its bull run. In fact, inflation protected bonds (TIPs) are already indicating that gold may be missing the inflation story. In the last week, as gold has faltered the price of the Treasury Inflation Protected Bond ETF (TIP) has begun to rise.
As you can see from this 5 year chart of the Gold ETF (GLD) and TIP, the relationship between these two assets is quite cozy. The recent divergence could be attributed to a stronger dollar – as investors mistakenly think that gold and the US Dollar always trade in opposite directions. This is simply not true. There have been plenty of periods when gold and the dollar trade in tandem for long periods of time ( a year). The distinguishing characteristic of these periods is rising inflation and rising bond yields ….sound familiar?
Yep, it’s the exact environment we could be headed into. So what do we do? Buy gold.