As the chart below illustrates, Chinese inflation has risen above levels where over the past five years Chinese authorities reacted with significant hikes in the country’s benchmark deposit rate. Yet, Chinese authorities may delay a hike, at least for the moment, to measure the effectiveness of targeted policies at the property sector and several increases to China’s reserve required ratio, now just below the series high of 17.5% at 17.0%. Nevertheless, even larger gains in producer prices will provide significant tailwinds to Chinese inflation in the second half; likely resulting in higher inflation and slower growth as the government is forced to react. This outlook will likely continue to weigh on Chinese equities, with the MSCI China index already down roughly 7% since the start of the year.
In the meantime, China’s real estate sector will likely continue to face the brunt of China’s ‘targeted’ tightening policies as authorities try to avoid the type of bubble experienced here in the U.S. The MSCI Chinese real estate index has lost 15% since its introduction on March 5. Given mounting cost pressure—combined with a recovery in the country’s export sector—there is also a fairly good chance that the Chinese RMB will re-initiate its course of gradual appreciation. This may become a very sensitive topic given U.S. mid-term elections and recent rhetoric between the two countries.