With bears waiting to strike...

You could buy on big dips , if you believe things will change in a year.

The RBI review last week contained no surprises. The central bank hiked policy rates by 0.25 per cent (25 basis points), which was bang in line with expectations. The interest rate cycle continues to move North but in a stable predictable fashion. Obviously, inflation is the underlying concern, at least for the RBI. The latest Wholesale Price Index (WPI) numbers for August 2011 suggests WPI is at around 9.8 per cent.

Data gathering on the inflation front has many dubious aspects. But let's take the broad details at face value. The WPI has three major sections, with different weights. Primary Articles(commodities) are up 12.6 percent year-on-year, fuel inflation is up 12.8 percent year-on-year (YoY) and manufactured goods are up 7.8 per cent. Incidentally, this is the provisional WPI number. It will be revised. Every revision in the past two years has been upwards. It is likely the revised WPI for August will show that inflation is actually trending above 10 per cent.

Will a tightening of interest rates help control prices? Probably not. The RBI has been tightening since March 2010 without discernible change. The effect of higher rupee rates on fuel and primary commodities is negligible. Those are driven by global factors, by the weather and government food procurement policy.

Higher interest rates can make a difference to inflation in manufactured goods (MG). But the MG inflation rate is already well below the overall WPI rate. This implies that industry is tightening its belt and shaving margins because it cannot afford to pass on input costs. Higher rates mean even lower margins for India inc.

The market has factored that in, given Q1 results. It has also factored in lower PE valuations, given a trend of rising interest rates. As of now, most analysts expect sales growth to remain reasonable (at least in nominal terms, given inflation). Margins are shrinking and will probably continue to shrink until the inflation-interest rate cycle turns around.

What may not yet have factored in, is the potential impact that persistent inflation may have on consumption demand. People tend to defer discretionary spending when the cost of living goes up. If that affects sales volumes, the picture could get really ugly. It hasn't happened yet but there could be a tipping point.

Looking forward, recessive global conditions should have a deflationary impact on commodities and fuel prices. If the Libyan situation settles down, supply dynamics in the crude and gas market will also be less strained. A fair to middling agricultural performance should also bring down food prices. Somewhere in the next 6-9 months, perhaps earlier, the inflation cycle should peak and reverse direction. That will have a lagged but beneficial effect on the domestic economy. The RBI will have to switch stance quickly in order to capitalise on the reversal when it occurs.

Three things could queer the situation. One is continuing global turmoil. If Europe, Japan and the US remain collectively weak, India will not really see accelerated growth. The second is domestic politics. The UPA is feeling insecure and 2012 has a full schedule of key state elections. Fears of prices going out of control could prompt a tight policy for longer than warranted. The third dangerous possibility is the unpredictable, ranging from terrorist attacks to wars, to a sudden currency collapse in Europe.

A case could easily be made for not tightening rates any further and even doing the counter-intuitive thing and cutting rates before inflation comes down. Since high interest rates cannot make a difference to the current key causes of inflation, why risk hurting consumption demand? It's unlikely to happen however. Central bankers are not hired to be counter-intuitive. However, if the above reading is correct, the economic situation could start turning around quicker than it seems possible at first glance. But that doesn't mean the market has hit rock bottom. The last phase of a bear market is actually when prices tend to tumble irrationally.

The last bear market lasted just 10 months (Jan 2008-October 2008) but the indices fell by over 60 per cent. This bear market has now lasted 11 months (starting November 2010) but prices have so far, fallen “only” 23 per cent from the peak of 6338 to the recent lows of 4700. The final phase of the bear market could be very destructive and take prices well below the 4700 level. In a situation when you can see a likely turnaround, a temporary weakness in price becomes a buying opportunity. If you reckon there will be the beginnings of a recovery inside 12 months, buying on any big price drops becomes a winning strategy.