In this month's commodities report, we address two phenomena - the slowdown and transition of China's economy, and the US shale gas revolution - that could profoundly change our entire macroeconomic framework.
The fear is that recent Chinese growth disappointments are a sign of things to come as Western export markets seize up and activity moves from capital stock investment to domestic consumption. But China has the firepower and the incentive to support investment levels to make sure its transition is smooth. And while it is well known that wealthier Chinese are likely to consume more food, electricity and cars, it is perhaps underappreciated that China plans a shift away from shipping low-value, low-commodity consumer goods to the US and Europe towards shipping high-value, high-commodity industrial goods and materials to Asia and Latin America. Meanwhile, some in China enjoy 30% pay rises, which means less commodity-price sensitivity.
Over the past 20 years, China has exported inflation via commodity prices but balanced that with disinflation via the price of labour and consumer goods. The next 20 years could see it export higher prices for labour and goods as well. Only brave investors bet on another 20 years of 2-3% inflation. Or rather, investors so petrified by the next 18 months that they are defaulting into a very brave bet for the next 20 years.
Predictably, the 'bravest' are in Bunds. German 20-year breakeven inflation stands at just 1.51%. Is that realistic, when Chinese workers are getting double-digit pay rises? US 20-year breakeven inflation is 2.15%. Why the 0.64 point spread, which has been rising since December and hit a peak of almost 0.9 at the beginning of June? Who knows. What we do know, is that it is largely accounted for by German nominal yields falling further and faster than US nominal yields. Real yields have been more in synch. If we assume 2.15% inflation for Germany, 20-year Bunds would have to yield 1.77% to preserve capital in real terms. They currently yield 1.13%.
But the reality could be much starker. First, US bonds probably under-price future inflation, too - just less so than Germany's. And second, the shale gas story suggests that bond markets might have the relative inflation picture the wrong way around. Shale is wiping out US gas imports; shale oil could eat into crude imports, too, reducing sensitivity to commodity prices, narrowing the trade deficit and offering support to the US dollar. That is a very different inflation scenario from Germany's, where shale is off the table and commodities are bought with a euro weakened to make peripheral economies more competitive.
Bond investors must not be paralysed by myopia. Look beyond the next 18 months if you are lending for 20 years. Look beyond Athens if you are lending to economies that trade globally. Understand that, even with a negative real yield of -0.38%, German inflation-linked bonds look like stupendous value next to their nominal equivalents. And consider what that tells us about the risks now inherent in our 'safe havens'.