Inflation takes a dip, but stickiness remains!!
Aug 17, 2011

Author: PersonalFN Content & Research Team

In the last three months in order to reduce the under-recoveries of the oil marketing companies, the United Progressive Alliance (UPA) Government had raised fuel prices (diesel by Rs 3 a litre, petrol by Rs 5 a litre, kerosene by Rs 2 a litre and domestic LPG by Rs 50 a cylinder), but this in turn has led to a detrimental impact on WPI inflation as it still remains over the comfort level (of 8.00%) of RBI.

For July 2011 while inflation did display a dip of 22 basis points (thus being close to most economist expectation of 9.24%), the stickiness still remains as the Government has restrained from reducing fuel prices despite a substantial correction in Brent crude oil prices. Moreover manufacturing products (which weighs around 65% in the WPI basket) have been steadily on an uptrend since February this year, when it crossed the 6% mark. Also, food inflation too is inching nearing the double-digit terrain (at present 9.90% for the week ended July 30, 2011) and revealing an upward bias due to increase in food grains and edible oil.

(Source: Office of Economic Advisor, PersonalFN Research)

Hence even though WPI inflation has dipped to 9.22% in July 2011 (from 9.44% in June 2011), WPI inflation is becoming more and more generalised across sectors. Moreover, the inflation data for the month of May 2011 too has been revised upwards to 9.56% from the provisional figure of 9.06% mentioned earlier.

RBI’s stance in taming inflation:

The Reserve Bank of India (RBI) still battling quite hard to tame WPI inflation since March 2010, but has not received much success in doing so. Since March 2010 it has raised policy rates 11 times successively as inflation continued to remain above their comfort range.

Policy rate tracker

	Increase / (Decrease) since March 2010	At present
Repo Rate	325 bps	8.00%
Reverse Repo Rate	375 bps	7.00%
Cash Reserve Ratio	100 bps	6.00%
Statutory Liquidity Ratio	(100 bps)	24.00%
Bank Rate	Unchanged	6.00%

(Source: RBI website, PersonalFN Research)

In its last monetary policy review (held on July 26, 2011) the RBI increased policy rates rather in a hawkish way – by 50 basis points (bps) to tame inflation, but the impact of the same is not magnified yet in the inflation data.

Our View:

We believe that despite inflation remaining over the comfort level, the RBI may have a limited room for increasing policy rates further, since at present the global economic factors led by the U.S. sovereign rating being downgraded (to AA+ with a negative outlook), along with debt overhang situation in the Euro zone may desist the central bank from increasing policy rates further. Moreover, the domestic factors such as the ones mentioned below, may also hold back the RBI from a further policy rate hike, at least in its 2nd quarter mid review of monetary policy 2011-12 (schedule on September 16, 2011):

Elevated borrowing cost
Elevated input cost
Chances of slowdown in consumer spending
Downward revision in GDP targets (from 9.0% to 8.2% by PMEAC)
Nervous sentiment in the capital markets
Manufacturing Purchasing Manager’s Index (PMI) at a 20-month low of 53.6 points in July 2011

Also the central bank would wait for the effect of normal monsoon to come into play, where the headline inflation is expected to cool down in the next couple of months.

Where you should invest as inflation risk remains?

But in order to safeguard yourself against inflationary pressures building in, you investors need to wisely focus on the following two major asset classes which can enable your portfolio deliver positive returns after accounting for inflation.

Equity:

At present the global economic headwinds will pave the path for the Indian equity markets. The House of Representatives (in the U.S.) have voted on August 2, 2011 for an increase in the U.S. debt ceiling limit by U.S. $2.1 trillion (making it U.S $16.4 trillion), and also agreed to cut federal spending by U.S. $2.4 trillion dollars or more. This in our opinion would purely bloat the U.S. economy (which already has been made a 92% increase in debt ceiling in the last 3 decades) and make its debt to GDP ratio daunting to manage.

Big fat U.S. debt ceiling

(Source: whitehouse.gov)

Moreover we believe while the debt ceiling limit is increased, the long-term risk of sovereign default crisis by the U.S. still remains because this decision of increasing debt ceiling limit is purely a case of postponing a sovereign default to happen. Also with persisting Euro zone debt crisis, may encourage the bear cartel to further tighten their grip.

But after the immediate knee-jerk selling in most equity markets around the world, we may witness Foreign Institutional Investors (FIIs) turning their head towards the Asian economies. But they would be watchful on export oriented economies such as China and Japan (as they collectively hold more than U.S. $2,000 billion of total US Debt) and this may be destructive for the respective countries reserves as well as foreign exchange earnings. Hence given that, FIIs would turn their focus on India, and continue to exude confidence due its inward looking Indian economy (which doesn’t focus much on exports), and the strong economic fundamentals which it has to offer such as luring growth, prudent policy measures, strong consumption story and lower debt to GDP ratio.

Hence taking a holistic view of the prevailing global economic scenario we believe that uncertainty will prevail, and thus one needs to be cautious while investing in equities and rather have a staggered approach. Indian equity markets look fairly robust but are susceptible to negative news from the U.S.

Hence while investing in equities we think diversification benefit provided by mutual funds can help to reduce risk (however one needs to stay away from U.S. or Euro oriented offshore funds in such a scenario). While investing in equity mutual funds we recommend that you opt for value styled funds and adopt the SIP (Systematic Investment Plan) / STP (Systematic Transfer 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.

Gold:

In our opinion the downbeat global economic headwinds make the case for gold becoming bolder. Moreover inflationary pressures are likely to haunt most emerging nations including India; and central banks across the world are likely to be vigilant on raising policy rates, which in turn would lead to smart investors taking refuge under the precious metal. It is noteworthy that gold has displayed a secular uptrend since a long time now. In 1971, the price of gold was about $32 an ounce and today (i.e. on August 14, 2011) it is $1,740.9 an ounce – which indicates that price of gold has gone up by 53 times over the last 40 years. Hence, nothing has changed for gold and we believe it will continue to maintain its upward trend in the long-term. Moreover if the U.S. dollar weakens due to bloated debt to GDP ratio, the northward trajectory would be clearly paved for the precious yellow metal. At PersonalFN, we recommend that you should have a minimum of 5%-10% allocation to gold. Invest in gold with a long term perspective with a time horizon of 10 to 20 years.

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