2 ETFs to Play China's Inflation Problem

Tony Sagami

On March 2, I wrote about the uncomfortably rapid increase in food prices and how you could profit from the forthcoming food inflation boom. I said:

“Over the last year, global food prices have increased by 29% partially due to weather shocks such as the Russian drought and floods in China. The real culprit is just old fashioned booming demand as the growing middle class in emerging markets, like India and China, simply are eating more and better.”

Stock market investing is always a moving target, so you have to regularly re-check your investment thesis to make sure that the fundamental drivers behind your strategy remain in force.

So let’s look at China’s newest inflation numbers, see if they are a problem and if they are getting worse.

The Chinese National Bureau of Statistics reported that its consumer price index rose 4.9% in February. That was a little worse than expected and it is identical to the January number. The details behind that headline number, however, paint a more ominous picture.

  • The government’s target rate is 4%, so the current figure means you can expect more foot stomping on the inflation brakes.
  • The Producer Price Index, or wholesale inflation rate, jumped to 7.2% in February. For the first two months of this year, PPI is increasing at a 6.9% annualized rate.
  • Food prices surged 11% on an annualized basis in February. That’s way above the comfort zone and high enough to cause some serious hardship.
  • Food isn’t the only commodity going nuts. Non-ferrous metals and fuel were up 14.8% and 8.9%, respectively.

I think the most-alarming news was that the government of China lowered its GDP growth target down to 7% for 2011. That is well below 2010’s 10.3% growth, and more importantly, tells me that China’s leaders are going to take some drastic and perhaps even painful action to kill off inflation.


Chart: The Wall Street Journal

Don’t take my word for it. Listen to what two Chinese leaders had to say:

HINT #1: “Following our economy’s successful recovery from the global economic crisis, inflation has also risen. In this situation, interest-rate policy is definitely an important tool that needs to be used,” said People’s Bank of China Governor Zhou Xiaochuan.

ACTION #1: China has already raised interest rates three times since October and steadily ratcheted up the share of deposits banks must hold in reserve to 19.5%.

But Mr. Zhou is pretty clear that more interest-rate hikes are on the way. Do you remember that old Wall Street adage about three steps and a stumble OR don’t fight the Fed?

For decades, academics and investment experts warned that the stock market was headed for trouble once the Fed embarks on a restrictive interest rate policy.

China isn't the only country worried about inflation.

It is essential that the recent rise in inflation does not give rise to broad-based inflationary pressures over the medium term. The governing council remains prepared to act in a firm and timely manner to ensure that upside risks to price stability over the medium term do not materialize.

— European Central Bank President Jean-Claude Trichet

There is no doubt that inflation is the most important issue which is to be addressed adequately.

— India Finance Minister Pranab Mukherjee

The increase in inflation that Russia has seen since the middle of last year has gone beyond the supply-side shock driven by the drought. We are currently updating our macro projections for Russia, and it is likely that the 2011 inflation projection will be revised upwards.

— International Monetary Fund

HINT #2: In a speech to open the annual National People’s Congress, Premier Wen Jiabao said the government would “make it our top priority in macroeconomic control to keep overall price levels stable.”

ACTION #2: On top of raising interest rates, China has raised down-payment requirements and instituted new property taxes. It has yet to use the biggest arrow in its quiver, which is to start using price controls.

You see, the Communist party runs a command economy and can do whatever it pleases. The fastest way to kill inflation is to make it illegal to raise prices.

The situation in China is pretty clear. Inflation is indeed a problem and China’s leaders are ready to take some serious action. I expect two things to happen as a result: (1) the Chinese economy is going to slow down and (2) China’s leaders may be able to slow inflation down a little but it won’t be able to stop it.

If those two scenarios are correct, there are two exchange traded funds that could do very well.
Lowering the 2011 GDP forecast to 7% already confirms that the Chinese economy is slowing, but if is slows significantly more than that, the Chinese stock market could be headed for a rough patch.

The ProShares Short FTSE Xinhua China 25 (YXI) is an ETF that’s designed to deliver the inverse of the daily performance of the FTSE China 25 Index. If China stocks slide, this ETF makes money.

Investing in inverse ETFs is a risky strategy, and betting against the Chinese economy has proven to be a dangerous bet. Therefore, this ETF isn’t appropriate for everyone. Heck, it isn’t appropriate for MOST investors, so think twice before you climb into this fund.
We live in a global economy, and even though China is trying to cool down its economy/inflation, most western countries are trying to inflate themselves out of their economic funk. Most European economies are struggling, and the spendthrifts running our country seem to have an unlimited capacity to print money.

The Global X China Materials ETF (CHIM) invests in companies that provide materials and commodities such as Zhaojin Mining, Jiangxi Copper, Shanghai Petroleum, Yingde Gases, Zijin Mining, Real Gold Mining, Sinofert Holdings, and Angang New Steel.

As you know, timing is everything when it comes to investing, and I am not suggesting that you rush out and buy either of these ETFs tomorrow morning. Do your homework and decide for yourself if these are appropriate for your personal situation, tolerance for risk, and especially whether or not you see inflation becoming a problem or not.

Best wishes,

Tony


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Posted 03-18-2011 11:00 AM by Tony Sagami