Hence, a couple of questions have come up: a) is this inflation transitory and b) with stock valuations stretched in many segments, would higher inflation lead to higher interest rates causing stock prices to fall.
Before getting into stock prices, let’s first try and understand the nature of inflation. Over the last 12 months, we have seen one of the sharpest spikes in global commodity prices, including agri-commodities. The Covid-driven downturn has been one of the peculiar ones, where the services sector has taken a bigger hit than consumables unlike the earlier downturns. Also, savings levels have not been impacted during this downturn globally, specifically in the US, thanks mainly to the government support.
This has led to higher demand in a supply-constrained environment and, hence, the inflation can be transitory in the medium term.
In India, crude oil price rise has been one of the factors behind the spike in core inflation. However, increasing global food prices could be a risk in the medium term, as India tends to catch up with global prices with a lag. Hence, India may see higher inflation in the medium term.
This leads to the second question i.e. would it mean an end to the stocks rally.
This may not be the case if one were to go by the past data. An analysis of past 20 years’ market performance suggests the market tends to do worst during a very low inflation environment i.e. sub 3%. It has performed best during a medium inflation environment. The market’s performance starts to dip amid very high inflation i.e. more than 8-9%. The reason behind that has been the fact that most of the time during low inflation phases the economy was in a bad shape.
Medium level of inflation tends to be great for commodity companies as well as financial companies, as they benefit both on growth and margins. However, it tends to be negative for commodity-consuming sectors like FMCG. The current cycle may see a further positive impact in these sectors amid medium inflation, as RBI, as well as the government, want GDP expansion and capital formation and, hence, a rising interest rate environment — which was a feature in earlier cycles — may get delayed.
Hence, pro-cyclical sectors may have one of the best environments in the last few decades given the low interest rates, medium inflation, higher liquidity and supportive government framework. But one should be a bit sceptical about some of the segments where valuations are really high. The rest of the market may keep performing in the absence of any external disruption.
(Santosh Kumar Singh is Head of Research at Motilal Oswal Asset Management Company. Views are his own.)
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