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In 1982, I was the publisher of an investment newsletter, STOCK ACTION. One of my recommendations was a company called Caressa Shoes. My wife, a PR exec at the time, was contributing to robust sales for Caressa because she contended its high heels were more comfortable than the other brands.

Recently she asked me whatever happened to Caressa. I was surprised to find her interest in this because I had not seen her in high heels in maybe 20 years, as now she is a grandmother in all-terrain sneakers. I looked into this company on the internet, and I discovered Caressa shoes are still manufactured by a Hong Kong-based company, Stella International Holdings (SLNLF.PK).

As I perused the financial reports for Stella, it became very clear to me that the effect of price increases in China can have a noticeable impact on everyday products here in the U.S. The purpose of this article is to focus on how the Chinese inflation rate, currency exchange rate and consumption may affect U.S. consumers.

Chinese Inflation. Stella sold 52.6MM pairs of shoes in 2011, about the same as 2010 (53.3MM). About 80% of those were exported to the USA and Europe. Last year the average price from the factory for a pair was $27.10 as opposed to $23.20 in 2010...a 17% increase in price.

This is meaningful for U.S. consumers because Stella fabricates shoes for several American companies:

Casual: Timberline, Wolverine (WWW), Deckers (DECK), Rockport, etc.
Fashion: Caressa, Kenneth Cole, Cole Hann, Nine West, etc.
High Fashion: Celine, Givenchy, Donna Karan, Emilio Pucci, etc.
Department Store: JC Penney (JCP) private label, etc.

Because of the numbers and styles of shoes, we look at this as a good representation of a fabricated commodity that is a basic necessity. The shoe price's reaction to Chinese macro factors may give us a clue what to expect with other Chinese exports to the U.S.

It is clear in the following chart that the Chinese inflation rate has been somewhat variable in the past few years. In 2011, it peaked a little over 6%, and that is substantially less than the 17% increase in the price of the shoes.

(Click charts to enlarge)

CHINESE INFLATION HISTORY

It should be noted that we recognize that graduating to more upscale brands may have an upward influence on the average price, but we think that is negligible when discussing more than 50 million pairs to essentially all market categories. There must be other factors beyond inflation for the 17% price increase.

Chinese Currency Exchange Rate. Although the company is based in Hong Kong, and the Hong Kong dollar tracks the U.S. dollar closely, the majority of Stella's shoes are fabricated in mainland China, where the Chinese yuan is the currency. The Chinese government held the conversion rate steady to the dollar for some time, until the summer of 2010, when it pursued a policy of controlled appreciation to the U.S. dollar.

The following chart indicates clearly when this occurred, and the consistency of the depreciation of the U.S. dollar in terms of yuans per dollar. The dollar is depreciating at about a 4% annual rate, and we expect that to continue for the foreseeable future.

We now have the second component in the 17% shoe price hike that is representative of basically all Chinese products imported in the U..S. For example, if the Chinese worker was paid 6.6 yuan at the start of 2011, that was worth $1.00 U.S. At the end of the year that was worth $1.04 U.S.

Chinese products such as computer peripherals and accessories, toys, sporting goods, household goods, clothing, furniture and others dominate those markets in the U.S., so a 10% price increase annually is nothing to ignore.

So now we presume that 6% of the hike was Chinese inflation and 4% was currency exchange changes, so we still have to account for 7%.

Chinese Demand for Chinese Products. So what does that have to do with the price of tea in China? I am glad I asked. Tea is another commodity and, like shoes, the major world producer is China. China actually produces 33% of the world's 4.1MM tons of tea, and it consumes 25% of the world supply itself. The China tea consumption has been increasing by about 5% per year and emerging markets, such as India, are also contributing to the increase in tea consumption. Apparently, the new affluence and the emerging middle class are the reasons for more tea sipping.

The following chart indicates a spike in the price of tea since 2005, as the rising emerging market demand soaked up excess supply. You may recall the first chart that indicated a variable inflation rate in China during the past four years, but there is nothing variable about the jump in tea prices. Inflation alone does not explain this price increase.

Obviously, there may be short-term explanations such as bad growing seasons and proliferation of teas on gourmet grocery shelves, but those do not explain the seven-year trend. We think that the explanation is the demand from China and other emerging markets, and we think that macro factor applies to other Chinese products imported into the US. We also think that will continue to cause price increases for the many imported products from China.

If you are interested in reading more about the tea business, here is an article that discusses the China impact in this commodity market.

Regarding Stella and the shoe example, it is notable that the fastest-growing segment of its business is the retail sales of shoes in China itself, which increased 55% in 2011 over 2010. We think that maybe 5% of the 17% shoe price increase is explained by this macro factor.

Conclusion. It would be dangerous to make sweeping conclusions based on the price action of these two products. It is impossible to theoretically evaluate all the influences that can affect the cost of such basic commodities as tea and shoes. The goal of this study is to attempt to demonstrate the effect of three macro factors associated with China:

  1. China inflation rate
  2. China currency exchange appreciation versus the dollar
  3. China consumption of products imported to the U.S.

We are now seeing the initial impact of these factors on American consumers, and it does not seem so serious yet. The price of Caressa heels on the internet is about $150, so a $4 increase at the factory level is not very significant. If we expect these macro factors to continue to trend as they have recently, the impact could become more serious.

In February 2012, China's inflation rate was down to 3.2%, and the currency appreciation continues around 4%. It is quite possible that the combination of these two, plus the added demand from China itself, will contribute 10% to the wholesale cost of Chinese imports across the board in 2012, and every year for the foreseeable future. By 2014, the wholesale price of Chinese products may be 25% to 50% higher than today.

Now the Federal Reserve is predicting that the U.S. inflation rate will be about 2% during that same period, and consumers can probably absorb that modest increase in prices. That is integral in the promise to keep the Federal Funds rate near zero until 2014. We wonder what tea leaves they are reading, because China-produced goods include some of the basics, like clothing, auto parts, toys and electronics. A surprise of even 1% more inflation than currently projected could turn delicate capital markets upside down. This Chinese factor could be the "straw that broke the camels back." You may wish to read my article on the effects of a zero interest rate.

The U.S. State Department has been encouraging China to let the yuan find its real value, but that may be something we should not push. If the Chinese government one day decided to lift the controls, we could see a much more drastic drop in dollar buying power for Chinese products. The theory is that the U.S. manufacturing segment will then be better able to compete against the Chinese.

We cannot fault the conclusion of that theory, but are cautious about the timing. It seems inevitable that these three macro factors will eventually price the Chinese products so that the U.S. alternatives can compete. That is, if there were actually any U.S. alternatives. Who wants to make shoes in the U.S. and who will man the assembly line?

There are two scenarios that we can weigh. The scenario that seems most likely to us is that we will see drastic inflation in the next few years on products specifically from China. There will be a contagion to competing products, resulting in overall higher inflation than projected for consumers. The freeze on Fed funds at zero will have to thaw, and bond holders will be holding the bag. The US manufacturing segment will ramp up gradually, but, for a time, the US will find itself a hostage to drastically higher prices for foreign goods...kind of like OPEC, except consumer products instead of petroleum.

The other situation is that the Chinese will let the yuan go, the U.S. inflation rate will stay below 2%, U.S. manufacturing takes off and everyone has a job and more money to spend...one can dream anyway.

We will explain in a future article how the inflation scenario may benefit U.S. investors.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Source: High Heels And The Price Of Tea In China: A Caution For U.S. Consumers