The Wholesale Price Index (WPI) inflation, after maintaining its stubbornness for nearly a year finally falls below the 9.0% mark, ending the month of December 2011 at 7.47% - its lowest level in two years. However, WPI inflation for the month of October 2011 was revised upwards at 9.87% from 9.73% earlier.

But if we observe the inflation numbers closely, it reveals that the fall has been mainly due to the high base effect witnessed for the same period last year. In December 2010, the inflation jumped to 9.45% from 8.20% for the month of November 2010, thus causing a high base effect. Moreover, the negative numbers thrown up by the food inflation were criticised by the former Chief Statistician – Mr. Pronab Sen saying, "The food inflation falling in the negative territory can be credited to both high base effect and seasonal factors. But again, I feel the food inflation numbers that we are seeing is a short-term trend. Inflation in food articles will go up again, once the base effect wears away. Food inflation will go back to 7 per cent in a few weeks."

  Inflation bug crawling down!

(Source: Office of the Economic Advisor, PersonalFN Research)

 

Thus it would be interesting to see how the inflation numbers in the ensuing months take shape. Moreover, once again escalating crude oil prices are a worrisome factor. If oil marketing companies, take a cohesive decision with the Government to increase fuel prices to correct their under-recoveries it could prove to have a detrimental impact on overall inflation. Developments taking place globally need to be closely monitored as tensions prevailing between Iran and United States could drive up the oil prices exponentially due to supply constraints imposed on account of closure of Strait of Hormuz, a vital transit route for almost one-fifth of the oil traded globally. The impact could be immediate and as such oil prices may skyrocket by 50 per cent or more within days.

 

So, would RBI go in for a rate cut in the upcoming monetary policy review?

We believe that positive statistical effect on WPI inflation may just facilitate the RBI to maintain a status quo in its monetary policy action, at least until March 2012. Hence, policy rate cuts appear unlikely, until March 2012; but we believe taking a view of liquidity in the system a cut in the Cash Reserve Ratio (CRR) is likely to ease the liquidity crunch.

 

Policy rate tracker

	Increase / (Decrease) since March 2010	At present
Repo Rate	375 bps	8.50%
Reverse Repo Rate	425 bps	7.50%
Cash Reserve Ratio	100 bps	6.00%
Statutory Liquidity Ratio	(100 bps)	24.00%
Bank Rate	Unchanged	6.00%

(Source: RBI website, PersonalFN Research)

 

Our View on inflation:

We believe that the high base effect in the ensuing months may further pull down the inflation numbers. However, if manufacturing item inflation and fuel inflation jumps up we may see the WPI inflation hardening. If things pan out positively, we expect WPI inflation to be in the range of 7.00% - 7.50% by March 2012.

 

What should equity investors do?

The drop in headline inflation is a positive cue for the Indian equity markets. But as mentioned earlier apart from positive impact of high base effect, the manufacturing item inflation numbers and stance on fuel price increase have to be gauged carefully. Equity investors should adopt calm and compose approach by staying invested and also investing further as, valuations in the Indian equity markets look fairly attractive and there is potential for robust future growth.

While fear of downbeat economic data being disseminated from the Euro zone still remains, staggering your investments would be an appropriate approach. We recommend that you invest in diversified equity funds as this will help reduce risk. However one should stay away from U.S. or Euro oriented offshore funds in such a scenario, and instead look at investing in domestic value style equity funds. Ideally you should opt for the SIP (Systematic Investment Plan) mode of investing as this will help you to manage the volatility of the equity markets well (through rupee-cost averaging) and also provide your investments with the power of compounding.

Remember, while investing select only those equity funds which follow strong investment processes and systems, and invest with a long-term horizon of at least 5 years.

 

What should debt investors do?

Well, we think that the current situation is attractive to take exposure to debt mutual fund instruments as interest rates are likely to consolidate at these higher levels before they start going down.

You can now gradually take exposure to pure income and short-term Government securities funds. Since longer tenor papers will become attractive, longer duration funds (preferably through dynamic bond / flexi-debt funds) can be also considered, if one has a longer investment horizon (of say 2 to 3 years). However, one may witness some volatility in the near term as there is always an interest rate risk associated with the longer maturity instruments.

With liquidity in the system being tight (ahead of advance tax payment obligation in mid-December), yield on the short term instruments are expected to move up slightly (say by 15 bps to 25 bps) thus making short term papers more attractive. Hence investors with a short-term time horizon (of less than 3 months) would be better-off investing in liquid funds for the next 1 month or liquid plus funds for next 3 to 6 months horizon. However, investors with a medium term investment horizon (of over 6 months), may allocate their investments to floating rate funds. Short term income funds should be held strictly with a 1 year time horizon.

Fixed Maturity Plans (FMPs) of 3 months to 1 year will yield appealing returns and can also be considered as an option to bank FDs only if you are willing to hold it till maturity, but you may not have a very attractive post tax benefit, as indexation benefit will not be available on FMPs maturing within 4 months. You should invest in longer duration funds, if the time horizon is of over 2 to 3 years. You can consider investing your money in Fixed Deposits (FDs). At present 1 yr. FDs are offering interest in the range of 7.25% - 9.40% p.a.

 

What should investors in gold do?

With the global economy being on an edge with the debt-overhang situation in the Euro zone, the risk of a contagion spreading still remains. This we think would make the precious yellow metal continue its northward journey, with sideways movement as well, if some intermediate positive news is disseminated from the Euro zone. Moreover, as long as inflationary pressures continue to remain due from manufacturing items and upward movement of fuel prices, we think that smart investors would prefer to take refuge under the precious yellow metal, thus hedging themselves against prices.

Hence, nothing has changed for gold and we believe it will continue to maintain its upward trend in the long-term.

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jcrollow@johnrollow.com Feb 25, 2012 You have great night on this topic. I agree with a lot of your info and your unique writing has made me think about many points. Thank you this content.

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