The inflation threat

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The major threat to global economic growth and stock markets this year is from rising inflation. In the US, consumer price inflation in December at 7 percent is at a 40-year high. Inflation in the Euro Zone is the highest since 1997. Inflation in UK at 5.4 percent is at a 30-year high. The response to rising inflation is monetary tightening. When interest rates go up, economic growth will be impacted, and for stock markets rising interest rate is negative news.

Inflation has been low in developed countries during the last decade. Even the ultra-loose monetary policy following the Global Financial Crisis of 2008 didn’t trigger inflation. Central banks couldn’t raise inflation to their targeted levels.

But the pandemic has changed the global inflation scenario. Globally, inflation is becoming a threat. Even now, there is a debate among economists about the cause of the present inflation. The Fed till recently held the view that inflation in US is ‘transitory’ and not structural. This transitory inflation, according to the Fed, is triggered by supply chain disruptions caused by the pandemic. Therefore, when the supply dislocations disappear, inflation would come down. But the Fed dropped the word ‘transitory’ in its policy meet in November.

In India, inflation is high, but not as much a threat as in the developed countries. But CPI inflation at 5.9 percent in December is threatening to breach RBI’s inflation target. An important contributor to inflation is the rising trend in commodity prices. This is reflected in prices of manufactured products too since firms are passing on the increased costs to consumers.

The Fed is expected to end Quantitative Easing by March this year and may begin raising interest rates soon after that. Three or even four rate hikes by the Fed are likely this year. ECB will also follow suit. Brazil and South Korea have already raised rates. The RBI is all set to move away from its accommodative monetary stance and raise rates. In brief, monetary tightening is going to be the dominant policy theme in 2022.

Even though rising rates are generally negative news for stock markets, it need not be so always. If GDP growth picks up and consequently corporate earnings improve, markets will react positively in spite of rising rates. This happened during 2003-07: The Fed raised rates 17 times – from 1 percent to 5.25 percent – during this period, but markets boomed. S & P 500 boomed from around 860 in early 2003 to1530 by late 2007. In fact, that was a period of global bull market. In India the Sensex shot up from below 3000 in May 2003 to above 20000 by December 2007. Sharp economic growth recovery and impressive rise in corporate earnings drove that global bull market despite hardening interest rates. So, along with monitoring inflation also look out for trends in GDP growth and corporate earnings.

Therefore, rising rates need not be negative for markets. If growth and earnings momentum sustain, markets will continue to remain resilient. So, watch out for trends in GDP growth and corporate earnings. More importantly, focus on sectors that are likely to outperform

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