inflation: Inflation period opens a window to make some promising bets

US headline inflation surging to its highest since 1982, to 6.8%, in November 2021 has been an eye-opener.

The post-pandemic world has notably changed. When Covid-19 broke out rapidly throughout the world in the initial phases of the pandemic, countries imposed stringent lockdowns to manage the burden on their healthcare infrastructure. While this led to a complete disruption of global supply chains, governments across the globe kept stimulating the economy by maintaining money supply at elevated levels. And even as this kept the overall demand resilient, it accentuated the supply-side inflationary pressures further.

Inflation, in the initial course, being led by the supply-side pressures, was expected to cool off as the economies reopened and business activities resumed to near pre-Covid levels. However, inflation has not cooled off since the economic reopening and has become more broad-based. Core inflation continues to remain resilient. The US Federal Reserve maintained an accommodative stance for a long period but is now clearly changing its narrative. In November 2021, private consumption expenditure (PCE) — one of the key inflation measures monitored by the Federal Reserve — advanced its fastest in the past 39 years, putting more pressure on tightening the monetary policy.

It is no secret that the Federal Reserve had a disproportionate impact on equity and bond markets around the world, and tightening periods are marked by a rise in market volatility. While inflation in India is also critical, the impact of the Federal Reserve on the global and Indian markets will continue to remain profound in the current circumstances.

India’s inflation trajectory has been very much on the expected lines. The Reserve Bank of India (RBI)’s monetary policy, too, is likely to remain in line with the consensus expectations, which are being reflected in the current bond yields. However, it is global inflation and monetary tightening by the central banks of the developed economies that will significantly impact the equity and bond markets of the world. The markets now seem quite confident that the Federal Reserve will announce three rate hikes in 2022.

Inflation challenge to be structural

Economists around the world are indicating that the current set-up of inflation is structural, and it might be in a long cycle. This changes many things for equity investors who will have to carefully decide what investment styles will deliver the most promising returns and which asset classes will outperform the others.

In the previous phases of higher inflation in India, which lasted from 2010 to 2014, the global inflation structure was markedly different from what it is today. Back then, when inflation in India stood in double-digits, inflation in the US had hardly breached the Federal Reserve’s 2% mark. However, this time around, the global indicators of inflation indicate that inflation is likely to persist. Moreover, developing countries pushing infrastructure investment through policy support, and the eventual kick-off in the private capex cycle across the world suggest inflation in key industrial commodities is likely to be a part of a long cycle.

Equities will still deliver excellent returns
While the spectre of inflation appears challenging, it is not necessarily bad for equities. Historically, tightening of interest rates has indeed led to short-term disruptions in the equity markets and spiked volatility. Fund flows, too, have been impacted with India witnessing significant outflows by the foreign institutional investors. However, it is observed that after initial volatility spikes and consensus building on the tightening of the monetary policy, equity markets bounce back quite well.

While the direction of the interest rate cycle has a bearing on the sectoral performance, the absolute level of interest rates, too, plays a critical role in the performance of the equity market. The current regime of interest rates is still low, and equities will continue to deliver excellent performance in the foreseeable future. Thus, it is only a matter of time before equities ascend further and touch new highs.

US Fed Rate vs. US Vix Index

Img1_US Fed Rate vs. US Vix Index

US Fed Rate vs. S&P 500 Rebased

img2_US Fed Rate vs. S&P 500 Rebased

US Fed Rate vs. Nifty Index Rebased

Img3_US Fed Rate vs. Nifty Index

US Fed Rate vs. India Vix

img4_US Fed Rate vs. India Vix

Value Investing to be the dominant theme

While equities as an asset class will overall witness good returns, not all equity assets and investment styles will deliver strong returns. As inflation remained elevated for the last year, the value theme stood as the most dominant investment style, outperforming other styles by a significant margin. Empirical evidence suggests that during periods of higher inflation, value stocks deliver encouraging growth. This can be attributed to value companies being primarily engaged in commodities, banking, and manufacturing sectors seeing better capacity utilisation, which reflects in superior stock performance.

Investment Styles – Price Performance

img5_Investment Styles – Price Performance

Commodities, Industrial goods, Banking, and Manufacturing to see higher allocation

The current inflation seems to be in a structural uptrend cycle, which means it is unlikely to cool off quickly in the near term. Hence, inflation proxies are very likely to perform well during this phase. Commodity plays would be direct beneficiaries. Moreover, the metals & mining sector seems to be well-poised as a long-term structural theme.

After commodity plays, we expect industrial goods to pick up as global capex by the private sector kicks in. The banking sector should also benefit as the cycle picks up in the forthcoming quarters. In this backdrop, allocations to the aforementioned sectors are expected to deliver healthy returns.

In conclusion, inflation can be a friend or a foe of the equity markets, depending on the market regime. The prevailing regime, being accompanied by a strong earnings trajectory for corporations, seems to be favorable for encouraging market performance. Indian corporates are well-positioned for a strong earnings cycle, backed by improved balance sheet strength and a stronger-than-ever earnings trajectory.

While the equity market is likely to see short-term hiccups, it will provide good opportunities to build an excellent inflation-proof portfolio comprising expertly curated companies from the commodities, industrial goods, banking and the manufacturing sectors.

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