Inflation is Surging in China. That's Great News for These Stocks...

David Sterman's picture

Tuesday, February 8, 2011 - 9:00am

by David Sterman

Policy planners in Washington just caught a big break. They've been repeatedly trying to prod China to strengthen its currency -- to no avail -- but larger economic forces may yield the same benefit. Prices are starting to bubble up in China and, if you connect the dots, you can start to see myriad benefits for the U.S. economy and U.S. stocks.

A slow build
The Chinese economy has been able to grow at a rapid clip for more than a decade without any price pressures -- a feat that is largely unparalleled in the modern era. Not anymore. Inflation in China started to perk up in 2010 and finished the year at a peak, with inflation now running close to 5%. (The official figure released by the Chinese government is a bit lower, while analysts at HSBC in Hong Kong think it's a bit higher than that rate).

The reasons for rising inflation are pretty straightforward and can be explained by the notion of "capacity utilization." As is the case with any industry, prices remain stable as long as producers have excess production capacity. But rising production can eventually create bottlenecks (typically seen at 80% of theoretical capacity at an industry level). To alleviate those bottlenecks, producers need to raise prices to account for their own rising production pressures. On a much broader scale, that's what appears to be happening in China. The country's never-ending growth spurt has finally created stresses in the system. Throw in the fact that prices for food and other commodities are starting to rise, and China's inflation rate appears set to stay at 5% -- or trend higher -- as long as its economy is in growth mode.

Lack of options
Rising prices have the effect of making goods and services relatively more expensive than in countries where inflation is dormant. In response, when other countries have found themselves with rising inflation, they have often chosen to devalue their currency to stay competitive. Argentina did that with great success nearly a decade ago. But China has no such option. As it stands, its currency, which is pegged to the dollar, has already notably weakened against surging currencies like the Japanese yen, the Australian dollar and even the resurgent euro. Pressure is on for China to strengthen its currency, not weaken it.

China can also look to raise interest rates to slow the economy, a process that is already underway. But policy planners are likely to stop the process of rate hikes before too long, unless it wants to expose the Chinese banking sector to the myriad risks presented by a sharp economic slowdown. Many suspect that a steep slowdown in the Chinese economy would lead to a crisis in the banking sector, which is counting on getting paid back for the massive amounts of loans that have been issued to the real estate sector.

The start of a trend
So if the Chinese economy is indeed on a path of relatively higher inflation than in the United States, then the whole dynamic of China being "the world's factory" will slowly start to change. On a simplistic level, 5% inflation in China and 2% inflation in the United States means that China becomes 3% more expensive than it was before. In the course of several years, that adds up. Of equal importance, a long-term strengthening of the yuan looks inevitable after years of massive trade imbalances that should have already made the yuan stronger by now. All told, we may be looking at a 20% increase in the cost of doing business in China in the next five years -- in dollar terms.

Who wins
The real beneficiary here is the U.S. worker. President Obama has repeatedly expressed a hope that rising U.S. exports will help us out of this morass in terms of job creation. Ironically, inflation in China may turn out to be his greatest weapon.

To be sure, the difference in labor cost is so stark in many industries that it would take a long time for China to lose its competitive edge. These are the least-skilled jobs, and the goods made have a very large labor component, so this segment of the economy really competes with places like Mexico, the Caribbean, Central America and Southeast Asia.

Action to Take -->
Yet it is in the industries where labor is less of a factor that will feel a more profound impact. For example, a great deal of furniture is made in China. It will increasingly cost more to make furniture in China, and rising oil prices means that shipping costs to send furniture back to the states are also on the rise. Sooner rather than later, furniture-making centers in places like North Carolina will again be competitive, which should yield new job creation.

You can also look for China to become less competitive in industries that are highly automated and very energy-intensive. Until now, it's always been easier to produce steel in China than in the United States. But that equation is fast-changing. U.S. Steel (NYSE: X), for example, will increasingly be in a position to defend their home market and more effectively compete abroad.

A changing currency/inflation landscape would also be a real boon for firms that establish their brands in China. Companies will enjoy firmer pricing and as earnings are repatriated back into dollars, foreign exchange gains will also fatten the bottom line. Companies such as Nike (NYSE: NKE), Coach (NYSE: COH) and Tiffany (NYSE: TIF) are just a few of the names that come to mind.

P.S. -- We've just identified six surprising events that could break your portfolio wide open in 2011. Knowing these pivot points in advance lets you focus your investing strategy like a beam of light in the dark... and make a lot of money in a hurry. Get them free by simply watching this video presentation.

David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.