9/4/2012
By David Urani, Research Analyst

More Articles by David Urani

Home Sales Still Climbing Steadily

Homebuilder Confidence Back Up

Market Valuation Entering "Fair" Territory

Following an influx of global manufacturing data, we now pretty much have confirmation that Europe, China and the USA are all seeing decreased production. Naturally, that's a big worry for the global economy. Yet, the market is still holding out hope that there will be government action as a result. In fact, the European markets rose higher on Monday on expectations that the Chinese government will take action as a result of their 49.6 PMI reading (anything under 50 indicates contraction).

It's becoming highly likely that China does some more to spur growth. However, there are a couple of big reasons that any China stimulus doesn't live up to expectations. As much as China's government loves to get involved in the economy, the fact is they are somewhat limited this time around by inflation.

The first reason is that poor crop conditions, particularly here in the US, are lifting world food prices. Soybean prices actually carry a fairly strong correlation to Chinese inflation, considering that food accounts for a third of their CPI. China knows that monetary easing and government spending can inflate, and food can be an especially touchy subject when considering the risks.

                                                   Soybean August 2013 Futures

Secondly, China's highly inflated home prices never really came back to Earth. Curbs have been put in place over the past few year and that seemed to stall the acceleration, but the latest reading on existing home prices in China for July showed a slight increase that leaves it less than 1% below the peak last year (according to ehomeday). Premier Wen noted on Friday that while government actions have generally stabilized prices, "controls over the real estate market are still in a critical period." Of course, he knows that relaxed monetary policy can undo their work.

As we saw today America's manufacturing PMI is at 49.6, a third month in a row of contraction. Naturally, that turns up the pressure even more on Ben Bernanke and the Fed to do that much-awaited third round of quantitative easing. Yet, like China we're not totally in the clear either. That same ISM manufacturing report that showed us in contraction also showed an alarming rise in input prices, to a reading of 54.0 from 39.5. Despite three months of deceleration prices have managed to lift higher.

And as noted before, we are seeing the same upward pressure on food prices, with corn prices remaining just below the record highs set last month and largely expected to rise over the next year.

                                                                  Corn December 2012 Future

And finally, there's also gas prices. They aren't quite above the $4.00 per gallon record set in 2008 but for this time of year they are setting records. Average national gas prices going into Labor Day weekend were nearly $3.80, a new high. High gas prices always have a negative effect on consumer confidence and corporate profit margins. And taken in tandem with high food prices spells a real problem as far as inflation is concerned.

For many, QE3 is all but guaranteed, and if the economy continues to deteriorate Bernanke probably will jump into action. However, he'll tell you himself that risk factors must be weighed, and these inflated prices are a big one. Certainly it's a strong reason for him to continue to second-guess monetary action.

David Urani
Wall Street Strategies