China PMI Points to Rising Inflation Risks

China Just saw the release of its two PMI indexes for February; the official CFLP (52.2 vs 52.9 prev), and the HSBC (51.7 vs 54.5). Though both indexes fell, they remained above 50 and generally did not point to any significant slowdown. But the warning signal that did come out of the numbers was for further upside inflation risks.

The HSBC "Input Prices" sub-index came in at 74.6 vs 71 in January, as a surge in commodity prices put increasing upward pressure on prices in China and other emerging markets. Another index to rise was backlogs of work, with comments from HSBC/Markit noting "about 17% of manufacturers said the rise in unfinished work was due to growing capacity constraints." The report also highlighted that manufacturers were broadly able to pass on higher costs to customers, which is good for profit margins (and thus earnings, and stocks - assuming no PE compression), but is a pretty blatant inflationary signal.

Thus, while it remains to be seen how the PMI readings will evolve through the rest of the year, the inflation specter will surely see further tightening, because in a place like China, spiraling inflation would be particularly destabalizing. So in terms of the stock market (FXI) outlook, there will likely be further tightening of liquidity, and further interest rate increases. Both of these factors will adversely impact valuations - but with valuations already in the low range, it's hard to tell whether or not the market has fully priced this in yet. On that note, its worth considering the economic fundamentals a little further.

On industrial production, the December reading saw a spike due to seasonal factors, while January stats do not get released, and February is typically lackluster due to new year holidays. But further out this year, there is the case for continued strong economic expansion. As part of the 5-year plan, the Chinese government is pushing for 10 million social housing dwellings to be started this year, and a further 8 million next year. This will have an immediate impact on construction and materials businesses, as well as consumer durables (during the fit-out/renovation process).

There's also the rising wages and employment demand factor that is starting to impact on domestic consumption (and thus enabling businesses to pass on any rise in costs). Add to that relatively stable, if not improving, economic conditions in the global economy, China will likely continue to see export growth. So while the Chinese economy will face some constraints from contractionary monetary policy this year, fiscal policy will remain expansionary, and the base case is probably another year of decent growth (of course there are some notable risks e.g. property).

So as for the stock market outlook, the key word is "uncertain." Given the relative exodus from China and emerging markets to developed market equities in recent times, the Chinese stock market has not done a lot. Indeed there could be a buying opportunity at the moment. But the key question is: "has the market fully priced in the inflation challenge yet?"

Disclosure:

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