Guard Against China’s Inflation

04/10/2008 12:00 am EST

Focus: ETFs

Carlton Delfeld

Editor, The La Jolla Letter and Pacific Gains

Carlton Delfeld, editor of Chartwell Advisor Global ETF Report, says inflation in China will become everyone’s problem, and he suggests some ways to protect against it.

A different kind of storm is brewing in China: inflation. The key component of the Chinese economic growth story has been its ability to keep prices low and top-line sales growth high. It has never been about profit margins.

Thus, the ability of China to serve as a giant global manufacturing platform was conducive to leaders in Beijing, as well as to export markets like America, which viewed low-cost Chinese imports as a way to keep a lid on inflation.

But the deflationary impact of China on world markets is now turning into an inflationary red flag. Wages have started rising rapidly, energy prices remain high, and food demand is exploding. Fresh evidence emerged in February as China’s inflation jumped to 7.1% from 6.5% in December. China’s consumer price index reached an 11-year high in January of 7.1% year on year.

Rising inflation is forcing Chinese manufacturers to try to defend their slim operating margins by raising prices for exported components which, in turn, will compress multinationals’ margins, since it is difficult in a weak economy to pass on higher input prices (such as energy, components and raw materials) to consumers in markets like Japan, America, and Europe.

Just take a look at recent reports by Japan Inc.’s big exporters. Canon, the world’s biggest digital camera maker, warned that earnings this year will fall short of market expectations. Sony’s 5% operating margin goal was also recently revised downward.

So, what does all this mean for investors?

First, avoid the large exporters of consumer products such as the already mentioned Sony and Canon, which are being squeezed by lower global demand and higher input and component prices. A stronger yen has not helped, either.

For your Japan allocation, take a look at the Tokyo Stock Exchange’s second section for smaller listed Japanese companies that are more domestically oriented and are trading at very attractive valuations. Rather than try to pick some specific companies, why not use the shotgun approach with the WisdomTree Japan SmallCap Dividend ETF (NYSEArca: DFJ). The fund holds roughly 500 stocks, and assets are widely diversified. Industrial and consumer cyclicals are the top sector weights at 27% and 24%.

Second, lean toward countries that are net exporters of commodities rather than net importers like China. A good choice would be the iShares MSCI Brazil ETF (EWZ). Brazil recently passed China as the top-weighted country in the MSCI Emerging Markets index.

Inflation is the cruelest tax of all, but smart investors can soften the blow to their portfolios.

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