Once again the inflation monster has raised its ugly head. The headline inflation as measured by the Wholesale Price Index (WPI) for the month of August 2012 stood at 7.55% as against 6.89% in the previous month. Moreover, the inflation for the month of June 2012 was revised upwards to 7.58% from 7.25% estimated earlier.

The graph below highlights the trend in the WPI inflation since August 2011. The inflation bug has been maintaining its stickiness despite efforts from the Reserve Bank of India (RBI) through its anti-inflationary stance last year. It is noteworthy that, again the inflation bug has spiked beyond the comfort range (of 6% to 7%) of RBI after just easing and being placed below the 7% mark last month.
 

Inflation spikes up again

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

The spike in the headline inflation can be attributed to the following components, which constitute the WPI:

Fuel & Power inflation: The fuel & power inflation for the month of August 2012 jumped to 8.32% as against 5.98% in the previous month.

Going forward there will be upward pressure on the fuel inflation given the fact that the Government has raised the prices of diesel by Rs 5 per litre. Although, the price rise is expected to reduce under-recoveries of the Oil Marketing Companies (OMCs) by Rs 20,000 crore there will pressure on the transportation charges of food grains as the All India Motor Transport Congress (AIMTC) has increased freight charges across the country by 15%.

Moreover, the Brent crude oil prices once again nearing the $120 mark due to sustained supply concerns, unrest in oil producing countries and Fed’s policy move of maintaining low interest rates until mid-2015, Thus this upward trend in crude oil is likely to have a bearing on the import bill of the country as well. However, the adverse effect of high fuel price may be negated to a certain extent if the rupee appreciates against the U.S. dollar, after the Fed’s policy announcement.

Food inflation: With a weightage of 14.34%, the food inflation for the month of August 2012 stood at 9.14% as against 10.06% in the previous month.

Going forward, with the trickling effect of high freight charges and below normal rains, food inflation may spike ahead in the coming months.

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

Now, that the Government has shown some action on the fiscal front (though just a start), it may put pressure on the Reserve Bank of India (RBI) to act on the monetary front by easing interest rates and boost the economy. However, with the inflation steaming up again and likely to do so in the coming months due to diesel price rise and high base effect, the RBI may not budge on from its stance and may once again maintain status quo on interest rates in the country.
 

Policy rate tracker

	Increase / (Decrease) in FY12-13	At present
Repo Rate	(50 bps)	8.00%
Reverse Repo Rate	(50 bps)	7.00%
Cash Reserve Ratio	Unchanged	4.75%
Statutory Liquidity Ratio	(100)	23.00%
Bank Rate	(50 bps)	9.00%

(Source: RBI website, PersonalFN Research)

 

Our View on inflation:

Inflation’s upward trend may continue in the coming months on account of diesel price hike, food inflation and high crude oil prices. It may take some more time for the inflationary pressures to recede and sustain at low levels. Unless, the Government comes up with concrete measure like increasing competitiveness of India’s exports, contain subsidy, raise the FDI bar in various sectors, etc. India would have to bear the brunt of high inflation along with muted growth.

What should equity investors do?

In the backdrop of the developments taking place in the developed world, wherein the Germany (the strongest amongst the Euro nations) has accepted the ratification of Euro 500 billion rescue package under the European Stability Mechanism (ESM) albeit with conditions and the Fed launching another stimulus programme (under which it will buy $40 billion of mortgage debt per month until the outlook for jobs improves), the emerging markets like India may witness a sudden flow of foreign capital which will help build a positive investor sentiment in the country.

However, any disappointment in the developed world may send negative ripples to the Indian economy as well as the markets. Under such a scenario of volatility it is better to adopt a staggered approach towards your equity investments. Remember any sudden or sharp dip in the equity markets should be cited as an opportunity to invest rather than liquidating your investments.

Moreover, when investing in mutual funds it is vital to select only those equity mutual 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?

Looking at the growth-inflation dynamics the Reserve Bank of India (RBI) may not go in for interest rate cuts at its upcoming second quarter mid-review of monetary policy scheduled on September 17, 2012. Apart from this, the liquidity situation too, seems to be comfortable as cited by the Deputy Governor, Dr Subir Gokarn.

Hence at present while taking exposure to debt mutual funds and fixed income instruments, one should clearly know their investment time horizon. Investors with an extreme short-term time horizon (of less than 3 months) would be better-off investing in liquid funds for the next 1 ½ months or liquid plus funds for next 3 to 6 months horizon. However, investors with a short to medium term investment horizon (of 1 to 2 years) may allocate a part of their investments to short-term income funds which should be held strictly with at least 1 year time horizon.

The present scenario also seems comfortable to look at longer horizon debt mutual funds. Thus, if you have a longer time horizon, then you can now hold some exposure to pure income funds. Since longer tenor papers will become attractive, longer duration funds (preferably through dynamic bond / flexi-debt funds) can be considered, if one has an 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 longer maturity instruments.

Fixed Maturity Plans (FMPs) of upto 1 year may for some more time yield appealing returns and can also be considered as an option to bank FDs only if you are willing to hold it till maturity. You can consider investing your money in Fixed Deposits (FDs) as well, before the interest rates offered on them are reduced. At present 1 year FDs are offering interest in the range of 7.25% - 9.00% p.a.

What should investors in gold do?

Even at the present price range, gold still can be considered as your hedge against the spiralling inflation. Moreover, with the announcement of the Fed’s stimulus policy commodity prices are expected spur up and gold will not be left out. Though there will be some sideways movements due to any temporary relief in the paining Euro nations, we believe that there could be volatility in the equity markets if the paining Euro nations like Greece, Italy and Spain do not come with some concrete solutions to get their finances in place. Also, with the Government battling to meet the fiscal deficit target (though as a start the Government has raised the diesel prices (much awaited) by Rs 5 per litre) amid a gloomy global economic scenario and a slowdown in economic growth, we think that investors would prefer to take refuge under the precious yellow metal despite elevated prices.

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

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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