High inflation, market valuations reasons to stay away from equities

The Consumer Price index (CPI) indicates that inflation is rising to near the limit of tolerance. However, the consensus is that a good monsoon will help to pull down food related inflation. The July 2016 CPI saw a year-on-year rise of 6.07 per cent above July 2015. Food inflation rose to 8.35 per cent year-on-year from 7.8 per cent in June. This is key since food has a weight of 45 per cent in the CPI basket.  

The data was well above the Reserve Bank of India’s (RBI’s) targeted level of five per cent for March 2017 and it was also above the consensus estimate of 5.9 per cent. Core inflation (Stripped of food and fuel) is reckoned to be running at around 4.5 per cent.

But, core inflation is also expected to get a boost since the Seventh Pay Commission has just put a lot of money into the pockets of government employees. Looking a little further down the line, if the GST is implemented by April 2017, as the government hopes, service inflation is also likely to get a cost push, assuming a higher tax rate.

The outgoing RBI Governor’s hawkish stance on inflation is now being vindicated. Raghuram Rajan has been criticised several times for his refusal to cut rates more than he has done (the policy rate has been lowered by 1.50 per cent in the past 20 months). But, these data justify that anti-inflationary stance.

RBI also often refers to household expectations of inflation, which it gauges from surveys that it conducts every quarter. The household expectations are now of inflation going into double-digit territory and that is considered danger signal.

The chances are, the central bank will not have much scope for rates cuts if this situation persists. The consensus is that, at best, one more cut can be expected before March 2017. Even that is unlikely if the pay hike arrears do have an inflationary impact. A single cut will not do much to stimulate credit demand and the ailing public-sector banks will probably not pass on any rate cuts.

This is the highest year-on-year change in the CPI in the last 24 months and it is a substantial rise from the June levels above 5.77 per cent. Since the retail inflation target until March 2021 is four per cent with a two percentage variation on either side, RBI would have cause to worry if food prices don’t abate.

At the same time, if GDP growth is supposedly occurring at 7.5 per cent, there is no particular reason for RBI to loosen up. So, we may see a long period of status quo on the central bank front. Indeed, if inflation does not abate soon, RBI would have the unpleasant task of raising rates.

The economy is also vulnerable now to external supply shocks if fuel prices do climb for some reason. That is not something that can be controlled due to the huge import component and we must simply hope that higher crude and gas prices don't come into the picture.

Speculations about fuel prices aside, equity valuations look severely stretched, assuming interest rates continue to run at current levels. The Nifty is trading at a PE of 23-plus, which is equivalent to an earnings yield of between four per cent and 4.5 per cent. That is way below the yield on Treasuries and it begs the question of why investors should buy equities at such valuations. Indeed, domestic investors now appear to be wary, it is only “zero-cost” money from FPIs that is keeping the market afloat.

The author is a technical and equity analyst