Last week we laid out our hypothesis for the eventual appreciation of the Yuan v. the U.S. Dollar. For those who missed it here is the summary…
China has lost control of the money supply which will eventually lead to uncontrollable inflation. The loss of control is due to the inexpensive cost of Chinese goods – foreign companies continue to purchase goods from China because it is the low cost producer. Without the automatic stabilizer of a flexible exchange rate this competitive advantage places the growth in the money supply outside the control of the People's Bank of China.
Fueling the Fire
The weekend comments from Chinese Premier Wen Jiabao coupled with remarks from Senators Schumer and Grassley places the global economy in a precarious position. The Premier’s remarks indicate the Chinese preference for political autonomy at the expense of economic stability. The Senators’ suggestions that China be punished with tariffs will only serve to fuel the political fire.
In our view, punishing China with tariffs is tantamount to the Smoot-Hawley Act that exacerbated the Great Depression. At the same time, the Chinese Premier’s resolve to keep the Yuan ’stable’ is creating an untenable hostile political environment. The opposing viewpoints will only serve to make the problem worse.
The End Game
In our view the end result will be a slowing Chinese economy. Eventually, the impact of rising inflation will overshadow the political posturing and the Chinese will allow the Yuan to appreciate. If played skillfully, the Chinese will be able to spin the move as their idea. If the Chinese do not allow appreciation, uncontrollable inflation will slow the economy of its own accord.
Since our view is for a slowing Chinese economic environment our trades remain the same; Short aluminum via Alcoa (AA) and Aluminum Corp. of China (ACH), short Hong Kong via EWH and short China via FXI. As is our trading protocol we will be adding to these positions on weakness.
Disclosure: Short EWH, FXI, AA and ACH
