By Darius Dale, analyst, Hedgeye

China’s third quarter and September economic data reaffirm a lot of what we already knew about the state of the world’s second-largest economy and even more about the global economy: growth is slowing, and inflation is accelerating.

Chinese annual GDP growth came in at 9.6% during the third quarter, well above consensus expectations but still slower than the rise of 10.3% during the second quarter. The country’s core inflation rate grew at its fastest pace in nearly two years, up 3.6% in September vs. 3.5% in August. Food inflation was especially high, up 8% over last year. This is significant, since roughly 36% of China’s citizens live on less than $2 per day, with food being their largest expense.

The ugly inflation data combined with a marginal deterioration in industrial production growth portend upticks in retail sales growth and rural wage growth. But it’s simply not good when growth is slowing and inflation is accelerating — the absolute levels of growth and inflation are less relevant to astute investors.

Think about it in investment terms: when was the last time you made good money when a company’s revenue growth was slowing and gross margins were contracting?

What is currently working in China’s favor is the Fed-sponsored, dollar-debased, yield-chasing rally we’ve seen globally. As such, Chinese equities, using the Shanghai Composite as a proxy, have rallied some 27% off their July lows.

We know China has been the world’s engine of growth for much of the last 18 to 20 months and, as expected, the data confirms growth is slowing. Now, China – and in fact, the entire world — is in a serious Catch-22. Here’s why:

1. According to the yield chasers of the world, the U.S. (China’s largest customer at roughly 20% of exports) “needs” QE2 to grow demand for China’s products.
2. QE2 crushes the U.S. dollar, which puts upward pressure on the prices of things Chinese citizens and businesses have to buy.
3. China gets smacked with more inflation, which leads to incremental tightening of Chinese monetary policy. On Tuesday, China reminded everyone how serious it is about fighting inflation with an “unexpected” rate hike of 0.25% in their benchmark one-year lending and deposit rates.

Indeed, China’s rate hike Tuesday reminded everyone across the globe the amount of correlation risk associated with yield-chasing fueled by excess liquidity. And therein lies the rub – more quantitative easing will force China (the world’s growth engine) to tighten incrementally, but less QE will cause the global Fed-sponsored, dollar-debased reflation rally we’ve seen across nearly every asset class to come crashing back down to economic reality.

I believe they call this “damned if you do, damned if you don’t.”

At the end of the day, incremental Chinese monetary policy tightening is bearish for Chinese growth, which itself is bearish for the speculative bid that has buoyed many emerging market equity markets and commodities. This round of Keynesian rallying is near its end.