Prepare for inflation

Inflation is emerging as a major threat globally. Inflation in March this year is at 8.5 percent in US, 7 percent in UK, and 7.5 percent in Germany which is regarded as an inflation hawk in the Euro Zone. In most developed economies, inflation is at the highest level of the last 3 to 4 decades.

High inflation in US has implications for equity markets globally. The Fed has been proved to be behind the curve and has turned increasingly hawkish after its March 2022 rate hike of 25bp. Now the market expects 200 bp rate hike by the Fed this year and this monetary tightening cycle is likely to end with the Fed funds rate at 2.75 percent. Bond yields have spiked sharply to above 2.8 percent and the dollar index has touched 100.  

A severe monetary tightening cycle can impact US growth and thereby global growth too. There are experts who believe that the current monetary tightening cycle may even trip the US economy into a recession even though the US economy is strong now. Attention is drawn to the ‘inverted yield curve’ – the long-term 10-year yield lower than the short-term 2-year yield – which normally indicates an imminent recession.  

It is important to note that a rate tightening cycle need not always lead to recession. During 2003-07, the Fed raised rates 17 times with the fed funds rate ending at 5.25 percent. During this period equity markets rallied globally. This was the period of the best global growth in recent times. Global GDP growth during 2003-07 was a record 4.5 percent annually. Now the situation is different. The spike in crude prices has impacted many economies. Global growth in 2022 has been revised down. RBI has revised India’s inflation projection for FY23 up to 5.7 percent from 4.5 percent earlier and has revised down India’s GDP growth rate to 7.2 percent from 7.8 percent earlier. The downward revision in growth rate and upward revision in inflation indicates that earnings expectations have to be toned down a bit.  

How should investors respond to this new macro dynamics?  

The RBI is likely to start monetary tightening in India from the June policy onwards. How many times the central bank will raise rates will depend on the crude prices, which in turn will be dictated by the war in Ukraine. If the war prolongs and crude remains above $ 100 for an extended period, RBI will be forced to raise rates by three or even four times. Rising rates will push more money into fixed income.  

Equity can beat fixed income returns 

It is important to appreciate the fact that at 6 percent inflation, real returns from fixed income will be negative. For an investor in the 30 percent tax bracket, 4 percent post-tax return from, say, bank fixed deposit will yield minus 2 percent return. Equity can beat this return handsomely. Investors must focus on investing in segments that will be least impacted by inflation and rising interest rates. 

Services is an area where inflation impact will be lower. In manufacturing, the inputs are goods which are impacted by inflation. In services the inputs are human resources not impacted by commodity inflation. Therefore, the inflationary impact will be lower in services than in manufacturing. Financial services like banking, insurance and AMCs, services like IT whose valuations have come down after the recent correction, infra services like port services and telecom are segments which will be least affected by rising inflation and interest rates.  

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