Inflation is a Reality in China

Inflation is a Reality in China8.5102

Here we've been spending all week showing how a second systemic banking collapse would broadside the Australian economy. But let's not ignore the other pillar of Aussie economic strength: China.

What if China hits the wall too? Or what if it tightens monetary policy and puts the breaks on the great credit binge, that at least partly, has led to such a strong rebound in prices for Australian exports to the Middle Kingdom?

Inflation isn't a risk in China now. It's a reality. Bloomberg reports that consumer prices rose by 2.7% in February. That's the fastest monthly growth rate in 16 months. And it eclipses the annual yield on savings deposits of 2.25%. Savers aren't beating inflation. And if they can't do that, they may as well spend the money. That could ignite a rising price cycle in China that monetary authorities want to avoid.

The logical step - if you're Vulcan - is to raise interest rates and slow things down (if you can). Or, China could do the hyper-logical thing and allow its currency to strengthen against other currencies. This would immediately increase the purchase power of Chinese savers. It would make more of Chinese growth come from domestic consumption than over-producing and exporting.

But when and how China allows its currency to strengthen is up to China. It will happen when it's in China's best interests to make it happen. Today, we'd argue, that day is a little closer - especially when the U.S. government ran its highest-ever monthly deficit in February at $220.9 billion. Who wants to buy U.S. bonds again? Just the primary dealers?

By the way, in case you were wondering, yes we were being sarcastic yesterday about jumping into the property market - at least the Aussie property market. Converting paper wealth into tangible assets does not mean you should buy those assets if they're over priced. And Aussie houses are definitely overpriced.

On the other hand, there are premier properties in the U.S. we'd have a look at. Most of these are not really cheap yet. But they are for sale. And that's a change. What does it mean?

Well first, we should say what we mean. The properties we have in mind are in our home state of Colorado. They are what you might call "prestige" properties. They're up in the mountains, zoned to prevent subdivision and numerous new neighbours, aren't far from an international airport, but give you a kind of mountain lifestyle you're after, if that's the sort of thing you're into (which we are).

What you'll notice these days is that there is a much more liquid market for those properties now. They're for sale, and they usually aren't. They come on the market once every twenty or fifty years, either at moments of great distress, or when there's a death in the family and estate taxes have to be paid.

What's going on today? Either the owners are selling because they have to (to raise cash). Or because they want to. It's time to retire now, in other words. Or, they see another big down leg in U.S. property coming and want to extract whatever value they can get now.

Mind you, if you're an investor, this certainly doesn't exclude you from being a buyer later. But it means that cashing up prior to the deflationary collapse is the best way to prepare for the collapse and buy the assets up cheaply later. Either way, we'd suggest the anecdotal evidence in the U.S. property market is that the top end is selling too.

But no, we wouldn't touch Australian residential property with a ten-foot barge pool. But see below for a very contrarian Aussie property strategy instead.

Why even bother with property when the stock market is making its biggest rally in 76 years? In New York, the S&P 500 has made a 17-month high. Granted, stocks are making higher highs on lower volumes. It's generally a sign that the rally doesn't have much breadth (or life). But isn't this just a new bull market climbing a wall of worry?

That could be the case. Our crystal ball is just as useless as the next guy's. But it's probably a mistake to buy the rally thinking stocks will make higher highs from here. This rally was driven by liquidity and bogus Fed money, not real earnings. The long-term of cash-flows that originated with the credit bubble are drying up. Investors are already paying too much for them.

That's not to say you shouldn't have a crack at predicting the future. For example, today's New York Times has a great article called "The Lithium Case". The article talks about how lithium ion batteries could replace nickel metal hydride batteries as the chief power source for hybrid and hybrid electric vehicles. Lithium ion batteries deliver nearly three times the amount of energy per pound as a nickel metal hydride battery.

The Times story goes on to list $1 billion worth of lithium projects being discussed in Argentina, Serbia, Nevada, China, Australia, Mexico, and Canada. It names the four biggest lithium producers in in Chile, the U.S. and Argentina. And it shows the difference between hard-rock lithium miners and lithium brines in places like Bolivia, which holds nearly half the world's lithium reserves.

All in all it's a great article, naming a prospective Australian stock. The problem is that the story is a year too late. Diggers and Drillers editor Alex Cowie is sitting an open position in a would-be lithium producer that's already produced triple digit gains. And that's just from the de-risking of the project. Future gains should come as the company produces lithium carbonate at a planned plant in China.

We asked Alex for a quick update and he said, "The Aussie-listed lithium stock we recommended twelve months ago was in its early stages, and has been more than busy since then. Since then it has ticked most of the milestones that take a company from adolescent to young adulthood. Mining has now started and buyers are already lining up. Mitsubishi has just signed up to buy the finished product, and others are waiting in the wings."

'As companies develop, they achieve certain goals and 'de-risk' as they do this. It is important to know where a developing company is in this process as to how much risk you take on. The chart below nicely illustrates how this influences the risk level."

"Our lithium company is in development phase, and soon to cross over into production phase. This means that we are well into the lower risk stage (green area), as most of the risk has been removed since we recommended the stock. Those investors that took on the risk have been rewarded with a big jump in the share price.

"With Diggers and Drillers stocks I like to identify where about stocks are in this process, and to offer you with stocks with different risk / reward profiles to suit different risk tolerances. There are a number of things that still need to be ticked off, so there is still some upside. Then when full production is soon achieved, investing in this company will be more about exposure to the rising lithium price. Those that invested when we tipped it last year have more than doubled their money already, but I firmly believe there is more to come."

Obviously we think Alex is on to something. But more importantly, this is what we're talking about when we refer to Black Swans. You may lose all your money. But if you're right, you definitely get rewarded for taking risk in these types of shares. We'd rather own a small portfolio of risks like this than a large diversified portfolio of blue-chip shares, where you get all the risk but none of upside leverage.

Of course, if we're right about the collapse of the shadow banking system and a sovereign debt crisis, these stocks are at risk too. This is why you should strongly consider reducing the amount of cash you have allocated to shares. Selling into market strength isn't a bad idea. Building cash position and then deploying it a small portfolio of shares and tangible assets is the next step.

There is no way we can know when the crack in the markets will come, or whether it will be a political or economic event that causes it. But it's a comin'. In the meantime, we reckon that if you built a humpy in your back yard and filled it with banked beans, bourbon and bullets; you'd outperform the All Ordinaries for the next ten years.

Not that we're a rating agency, but we'd give the Humpy Portfolio a Triple "bbb" rating (beans, bourbon, bullets). There are probably other tangible asset classes that will perform even better in a hyper-inflationary currency collapse: vodka, salt, pepper, cigarettes, petrol, and gold to name a few. Suggestions for the Humpy Portfolio are welcome. Send yours to dr@dailyreckoning.com.au

Dan Denning
for The Daily Reckoning Australia

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