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Why China's PPI deflation matters

China reported PPI deflation at a much slower pace of -0.8% y/y in August, once again better than expectations, and better than the July figure of -1.7%, and a vast improvement from the worst point of -6% at the end of last year. China's PPI inflation has made a remarkable turnaround that has caught most by surprise. But so what? Why does China's PPI (Producer Price Index) inflation or deflation matter?

The answer depends on whether you're interested in emerging markets...

The historical pattern is that higher (or at least positive) PPI inflation is generally consistent with better performance by emerging market equities. So a transition to PPI inflation from deflation for China will spell good news for the sustainability of the emerging market equity rally that has taken place since the lows of January this year.

That's where it gets complicated. The reason for the rebound is 3-fold: a. Fiscal stimulus in China; b. Renewed property price bubble in China; and c. Rebound in global commodity prices (partly as a result of the stall in the US dollar bull market).

So the first one is temporary in nature, the second is unsustainable and dangerous, and the third point is anyone's guess as the US dollar could speed off again at a moment's notice (by the Fed). But in the short-term (say 3-6 months) these factors are somewhat baked-in and China will most likely head back into PPI inflation in the coming months. At the margin this will probably be supportive for emerging market equities, but it's well worth keeping an eye on those 3 factors for any signs of a turnaround.

In the case of the property market, no property market in the world has ever gone up and only up, and if it does roll over then you can expect a return to PPI deflation. But more on that in a future article.

Bottom line: China is heading for PPI inflation, this is typically supportive for emerging market equtiies, but the drivers of the PPI rebound are likely to be temporary.

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