The latest set of inflation numbers indicate inflation is falling in both the Wholesale Price Index (WPI) and Consumer Price Index (CPI). WPI in April has supposedly fallen below five per cent to around 4.9 per cent, while the CPI has dipped below 10 per cent, to around 9.4 per cent. As always, when it comes to Indian government statistics, there are anomalies in the data if one examines details.
However, for argument's sake, accept that the rate of inflation is really falling. The Reserve Bank of India (RBI) seems to be inclined to this view. The central bank has been very cautious in its pronouncements until recently, when the WPI dropped below five per cent. But it has also cut policy rates consistently since May 2012. It would not have done that without a reasonable degree of confidence about a downtrend in prices.
Banks have not yet appreciably cut lending rates. But quite a range of real interest rates - fixed deposits and government treasury yields, for example - are negative if one uses the CPI as a benchmark. Rates could come down by another 125-150 basis points over the next year to 18 months and, sooner or later, banks would have to cut.
This combination of falling interest rates and stabilising prices should translate into faster growth in general. It should also offer major relief for rate-sensitive businesses. There would be cost savings, which should lead to growth in margins.
However, in terms of demand, one mustn't forget roughly two-thirds of India's GDP comes from consumption. A significant proportion is discretionary. Consumption has collapsed over the past two quarters and discretionary spending, in particular, shows little sign of revival. The automobile industry, my personal touchstone for big-ticket spending, has seen negative sales for several months. If discretionary spending doesn't improve substantially, there is a ceiling on earnings growth.
Discretionary spending depends on inflation expectations and those are high. It will take more than a month or two of slightly lower inflation to change expectations. Nobody trusts the official data.
The average citizen doesn't look at indices. He or she has become inured to the cost of living rising uncomfortably over several years and expects this pain to continue. The data miner who does look at the indices notices a pattern where price index data are consistently revised upwards after an initial low estimate. Businesses have also suffered inflation and high interest outgo through multiple quarters and are likely to be cautious about discretionary spending, such as investing in expansions.
The high inflation expectations, coupled to an actual trend of falling inflation, could create a opportunity for investors. GDP growth recovery will be slow and come with a lag but earnings net of interest will probably climb quicker than GDP because of lower interest outgo.
Some rate-sensitive stocks have already started doing well but there is plenty of upside here, since the downtrend in interest rates could last a year or more. There are also plenty of stocks that haven't taken off yet.
In fact, there hasn't been a bull market at all in smaller stocks, where there is no foreign institutional investors' presence. The domestic investor, both institutional and retail, has remained consistently bearish. As and when Indian inflationary expectations change for the better, this bearish attitude will also change.
One month of lower inflation numbers is not a trend. There are big risks in jumping into the stock market on the basis of numbers that could well see adverse revisions. But if the investor is early into an economic revival, the returns are also likely to be substantially better.
This might be the time to start looking at relatively smaller rate-sensitive stocks. These have been ignored by FIIs and domestic investors alike. The downside risks are less, simply because these have not risen as much as the top 200-odd stocks which receive FII and domestic institutional investors' attention.