Inflation has emerged as a major threat to economic growth and markets, globally. In the US, inflation touched 8.3 percent in April; in the Euro Zone inflation is at 7.5 percent and in the UK at 9 percent. In countries like Turkey and Sri Lanka, there is hyperinflation. Relatively speaking, inflation in India is lower; but it is rising menacingly and has negative implications for the economy in the short run.
A combination of factors has contributed to the rising inflation. Humungous liquidity created by the leading central banks of the world, particularly the Fed, supply chain disruptions caused by the widespread lockdowns in China and the spike in energy and commodity prices triggered by the
Ukraine war have combined to produce high levels of inflation, globally. Central banks are tightening monetary policy.
What are the implications of high inflation and monetary tightening for stock markets? How should investors respond?
The Fed is on an aggressive monetary tightening path and the Fed Chief Jeron Powell has vowed to “raise interest rates till inflation comes down.” After the 50 bp rate hike in May, two more rate hikes of 50 bp each are expected in the next two FOMC meetings. Even though further Fed actions will be data dependent, markets have factored in a terminal Fed funds rate of around 3 percent in 2023. This has already impacted capital flows and currency markets. The dollar index has shot up above 103 and the US 10-year bond yield is hovering around 3 percent. This is unfavorable for equity markets in the short run, more so for emerging market equities.
In India, CPI inflation for April rose to 7.79 percent and WPI inflation shot up to 15.08 percent. Indications are that inflation will continue to be high, for some time. Like the
Fed, RBI too proved to be behind the curve as evidenced by the MPC’s out-of-cycle rate hike of 40 bp on May 4. More rate hikes are in the offing. Further rate hikes totaling 75 bp are likely in the June and August policy. This will impact economic growth in India. RBI has already revised down India’s GDP growth rate for FY 23 to 7.2 percent. High inflation and interest rates will impact corporate earnings too.
It is important to appreciate the fact the situation is highly volatile. The big unknown factor now is how long the Ukraine war will linger. Since the war is the single most important factor that has pushed up energy and commodity prices, if the war suddenly ends it can trigger a crash in crude and other commodities leading to moderation in inflation. Consequently, central banks may turn less hawkish than they are now. This will be positive for markets. But this is, presently, an unknown area.
Adopt a cautious investment strategy
It is better to adopt a cautious investment strategy in these highly volatile and uncertain times. Even after the recent corrections, the market is not cheap. At 16000, Nifty is trading at above 18 times FY 23 earnings. This is higher than the long-term average of around 16. At the same time, valuations are fair in certain pockets. Therefore, investors can use the weakness in the market to slowly accumulate high quality stocks in sectors like financials, IT and select autos. In fact, calibrated buying in small quantities, in blue chips across sectors, would be a safe investment strategy. SIPs should be continued and, if possible, the amounts can be raised.