Markets on a high, inflation trends a worry

Corporate results have met expectations; CPI, IIP are at low levels means economy is in doldrums

Another week, another new high for Indian markets. This is part of a global trend, with most of the world’s large markets trading at or close to their record levels. The Q1 corporate results have, so far, been up to expectations. This week features an important central bank monetary policy meeting and possibly, political news which could move the markets. 

The US Federal Reserve has made four successive rate hikes and also discussed launching a “reverse QE” where it starts to sell off some of the bonds acquired during that long period of quantitative easing. However, inflation in the US is at just 1.6 per cent, which is well below the Fed’s targeted levels of two per cent. High-speed data such as car sales looks soft, too. It’s possible the Fed will just maintain status quo. 

The Bank of Japan will continue with its own QE programme and it continues to hold a negative policy rate. The European Central Bank (ECB) has also decided to hold status quo but it will “discuss” unwinding its own QE “in autumn” whatever that might mean.  Europe seems to be enjoying its best phase of corporate expansion in many years and inflation has picked up but it’s generally well below the two per cent target level for the ECB. Indeed, the ECB may even expand its QE (which is running at €60 billion/month) if inflation eases off. 

If the Fed doesn’t hike, traders might spark another global rally. The dollar could see some selling — the rupee has already hardened substantially on foreign portfolio investment inflows. Meanwhile, Donald Trump’s ties to Russia and alleged collusion between Russian state-backed hackers and the 2016 presidential campaign continue to be under investigation. If this blows up into impeachment, or even threatens to go that far, there is bound to be an effect on market sentiment. It has already damaged this US administration’s ability to push through meaningful legislation.

China is another story. The China Banking Regulatory Commission has said it will crack down on risky financial behaviour, and take steps to reduce “chaos” in the market. This doesn’t involve rate hikes but it could tighten the flow of credit to bubbly sectors like real estate. Despite that, Chinese stocks are likely to climb due to inclusion in the MSCI Emerging Markets Index from June 2018. Passive index funds will mandatorily buy those stocks in 2018. Hence, active investors are already front-running and buying into Mainland stocks.

In India, corporate results have been reasonable. Hind Unilever delighted the markets. Infosys and TCS both scrambled in at close to the admittedly low consensus expectations. It’s worth noting, however, that both information technology giants saw manpower reduction in Q1, 2017-18 and the portents don’t look good for the sector. ITC took a beating when the Goods and Services Tax Council plugged in another cess on cigarettes.

Reliance Industries announced a 1:1 bonus and a new scheme for Jio. It has maintained extremely high gross refining margins and operating profits and both comfortably beat consensus estimates. However, interest costs have almost doubled and given that Jio will require continuing massive expenditures in the future, there may be a blip at some stage. Incidentally, the Jio announcement of free feature phones and flat tariffs has caused another disruption in the telecom industry and telecom stocks are being sold down yet again.

The latest inflation numbers indicate a worrying trend. The Consumer Price Index for June dropped to the lowest in five years at 1. 5 per cent year-on-year. The Index of Industrial Production for May is also pretty low at 1.7 per cent, well below consensus. If those numbers are to be trusted, the economy clearly is still in the doldrums. Almost everybody expects a rate cut and other monetary loosening measures from the Reserve Bank of India (RBI) in early August. There’s already an anticipatory bull run on bond street as a result. Speculatively, if the RBI does cut and the Fed doesn’t hike, there could be some selling pressure on the rupee.

However, there is said to be dissension in the Monetary Policy Committee about the wisdom of rate cuts at this instant. The RBI has several other problems. Apart from attempting to deal with the non-performing assets crisis, it has not been able to submit its own financial accounts. This is due to the fact that, for some reason, it has not yet been able to count the cash returned during the last two weeks of demonetisation. This would be funny if “demon” hadn’t damaged so many businesses, led to multiple deaths in queues and caused such massive job losses in the informal economy. There are also rumours of a rift between the finance ministry and the RBI. So nobody is quite sure what the RBI will do.

The technical situation looks quite rosy of course given successive new highs. Valuations are currently at PE 25 for the Sensex-Nifty and at PE 32 for mid-caps. Those are tough to justify fundamentally but the advent of GST means that investors may ignore Q1 results if those are bad.

As of now, the market is likely to continue heading north, at least until the RBI’s next policy meeting. But if it breaks, we could see a 10-15 per cent correction.