Inflation expectation in the US measured by the 5-year breakeven inflation has risen to 2.94 per cent, the highest in 16 years. The persistence of a list of inflationary factors have led to a rise in core inflation and feeding into views of a potential wage-price spiral, especially when the labour market has tightened. US unemployment rate declined to 4.8 per cent in Sep ’21 from the post-pandemic peak of 16.5 per cent, which is the steepest post-recession decline in 80 years.
Tracking these trends, central banks have now abandoned the earlier often repeated perception of transient high inflation, and are metamorphosing into a more hawkish stance. US Fed officials are also accepting that high inflation, which has surged to 4-5 per cent will be enduring. The Bank of England is preparing markets for a steeper and sooner rate hike cycle. And several central banks like New Zealand, Norway, Czech and Russia have already initiated rate hikes.
Overshooting global inflation, particularly in the US and other advanced economies, could quicken monetary policy normalisation, harden the risk-free rate and curtail global excess liquidity; these have been the quintessential drivers for global equity valuations since March 2020.
The IMF’s base case (October’21) assumes that inflation in both advanced and emerging economies would remain anchored to 2 per cent and 4 per cent, respectively, by end-2022 and would peak at 3.6 per cent and 6.9 per cent around end-2021. However, the risk is tilted to the upside owing to factors such as a) persistence of supply bottlenecks, aggravated recently by power shortages, b) tightening labour market, c) emergence of adaptive adjustments for pipeline inflation, and d) possibility of lower post COVID-19 potential GDP.
Hazarding a guess on the duration of the global energy shock is fraught with significant uncertainty. However, three inferences are worth highlighting.
First, the pervasive surge in energy cost appears inconsistent with the structural backdrop of declining energy consumption especially since 2014, mainly in the OECD countries. Second, the rise in global temperature anomalies since 2014 implied warmer winters in OECD countries until 2019 and lower heating fuel consumption. Contrastingly, winters in 2020/21 Europe and US were cooler and possibly the La Nina effect will relapse even in 2021/22, thereby sustaining near-term fuel demand. Third, we would like to believe that the abnormal spurt in energy since post-Covid lows is due to frictional factors, particularly in Europe and China.
Thus in the base case, we see an energy shortage lasting for 3-6 months (i.e. till Apr’ 2022), and believe it would impact the cost of production, as well as curtail supplies across sectors, due to power rationing, especially in China. This can extend the existing supply side constraints longer. The risk of cooler winters in the US and Europe, along with negative elasticity with inventory levels (-4.2x) and constrained supply from OPEC+ can push Brent crude up to over USD 100/bbl.
From India’s perspective, beyond the near-term dip in inflation, as the base effect wears out and we see the cumulative impact of rising cost inflation, including fuel and power costs, improving pricing power and narrowing of the consumption demand gap, it could imply a catch-up in inflation in the next 12 months to 6.5-7 per cent. Thus, contributing to a change in the RBI’s stance towards overt normalisation in addition to the impact of a higher US Fed rate and stronger USD. We expect the RBI to hike policy rates in 2022; the desirable real rate for India is around 1 per cent, significantly higher than the current real rate of -2 per cent. Hence, there is considerable scope for policy rate normalisation as well.
Notwithstanding the post-Wave-2 demand recovery, corporate India’s performance over the next few quarters would be impacted by a) elevated material costs, b) a rise in crude oil and energy prices, c) the impact of domestic coal and power shortage on various industries, higher raw material and logistics costs and higher inflation on wage costs and d) supply shortages of imported inputs/finished products from China, which is slowing and experiencing power rationing. These will moderate earnings expectations going forward. Large companies that enjoy market power, services sectors and those that compete with Chinese imports will likely do relatively better.
Higher crude prices generally have a positive impact on valuations for Indian equities so long as it remains below USD 100/bbl; this scenario is typically accompanied by better growth. But a stagflationary situation of high inflation and lower growth typically emerged once crude prices goes beyond USD 100/bbl. That along with hardening risk free rate can trigger an inflection.
The risk to valuation is high now both on historical and global comparisons. a) Nifty price/book at 4.3x trailing is 20 per cent higher than 2010-19 average; CY21 P/B at 3.6x is 24 per cent higher than the past-5-year average. Forward valuations for Indian benchmarks are 70 per cent higher than the average of 23 major global indices and are second richest after the US. The relative valuation of small/large caps has declined somewhat from Jul’21 peaks of 83 per cent to 80 per cent currently, but is still rather high compared with the trend level of 65 per cent.
We observe a strong correlation of retail (and domestic) investments and valuations since the demonetisation days (2016). Contribution of the retail segment to market turnover increased from 39 per cent to 65 per cent at the peak. This is explained by surplus banking sector liquidity emanating from an overly accommodative RBI, aggressive un-sterilised FX build and low credit growth. Thus, the RBI’s LAF balance currently stands high at INR 7tn or 4.6 per cent of bank deposits vs the desirable level of 0.5 per cent. The expected decline in RBI’s FX reserve in response to US tapering, lower FII flows and widening CAD, RBI’s policy normalisation (stoppage of GSAP purchases) and pick in domestic credit growth would collectively narrow surplus domestic liquidity in coming months, thereby leading to a valuation correction.
