The inflation bug seemed to have brought in some respite in the year 2013. The WPI inflation data for the month of January 2013 stood at 6.62%, thereby outpacing the expectations of 7.0%. Thus now after plateauing for 14 months above the 7.0% plus mark, headline inflation has finally dipped, making a four-year low.
 

WPI Inflation eases further

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

The drop in WPI inflation for January 2013can mainly be attributed to:

Manufactured inflation:
The data here revealed some softening in prices of manufactured products (which have a weightage of 64.97% in WPI), as the inflation in this category reduced to 4.81% in January 2013 from 5.04% in December 2012.

Fuel & Power inflation:
Likewise fuel and power inflation (which has 14.91% in WPI) also descended rather noticeably to 7.1% in January 2013 from 9.38% in December 2012. Moreover, the data for the month of November 2012 too was revised downwards to 9.97%.The correction in prices of aviation turbine fuel led to a descending move in this group.

However food articles (which have a weightage of 14.34% in WPI)continued to depict inflationary pressure as it rose to 11.88% in January 2013 from 11.16% a month prior.Thus the trend of price moderation which was evident on a month-on-month basis, in few months prior to December 2012was exacerbated by monthly price pressures in this segment.

Thus it can be said that rising cost of food articles had some cascading effect to reduction in prices seen in manufactured goods and easing fuel & power cost.

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

The Reserve Bank of India, keeping a view of moderation in in non-food manufactured products inflation, domestic supply-demand balances and global trends in commodity prices, has projected baseline WPI inflation for March 2013 at 6.80% (revised downwards from 7.50% as set out in the 2nd quarter review of monetary policy). With WPI inflation now dipping to a four-year low, there seems to be some respite, but with the pass-through of diesel price adjustments over the next several months and the possibility of adjustment in other administered prices, plus with food inflation remaining high; the movement WPI inflation is expected to remain range bound. Going forward the risk also emanates from ascending trend in Brent crude oil prices and weakening in the Indian rupee. The retail inflation too for January 2013 too remains in double-digit at 10.79% driven by higher prices of vegetables, edible oil, cereals and protein-based items.

Thus in the backdrop of the above, we think the RBI would very watchful. Recently in the 3rd quarter review of monetary policy 2012-13 has reduced policy rates and CRR – both by 25 basis points (bps) each, and some banks passed this on to customers in the form of reduced lending rates. Going forward, we think the RBI would also assess the impact of Union Budget 2013, and thereafter decide its stance on policy rates and liquidity measures. In our view it seems unlikely that the RBI would cut rates in its next mid-quarter review of monetary policy 2012-13 (scheduled on March 19, 2013), but instead the central bank may reduce rates now in its monetary policy 2013-14 (scheduled on May 3, 2013-14), depending upon growth-inflation dynamic and twin deficit situation.
 

Policy rate tracker

	Increase / (Decrease) in FY12-13	At present
Repo Rate	(75 bps)	7.75%
Reverse Repo Rate	(75 bps)	6.75%
Cash Reserve Ratio	(75 bps)	4.00%
Statutory Liquidity Ratio	(100 bps)	23.00%
Bank Rate	(75 bps)	8.75%

(Source: RBI website, PersonalFN Research)

 

Our View on inflation:

Although WPI inflation is now placed at four-year low of 6.62%, the risk now emanated from:

• Rising Brent crude oil prices;
• Food inflation;
• Weakness in the Indian rupee (leading to imported inflation); and
• Pass-through of diesel prices

In the coming months, fiscal management of the Government would be closely monitored and if Government overshoots the limit of borrowing as it has had set for FY13, then rupee may again take a beating. Food article inflation may not go down as expected if supply constraints are not corrected. Also the recovery in China could also stoke-up commodity prices leading to inflation in India as well. Thus for about a couple of months, we see WPI inflation plateauing around the 7.00% mark.

What strategy debt investors adopt?

The RBI would continue to condition and contain perception of inflation in the range of 4.0% - 4.5%; which is in line with the medium-term objective of 3.0% inflation consistent with India’s broader integration into the global economy. Going forward the RBI’s monetary policy action would be guided by evolving growth-inflation dynamics and the management of twin deficit risk.

As far as liquidity situation is concerned, we expected it to remain tight in February 2013 with the central and the state Government borrowing Rs 48,000 and Rs 20,000 crore respectively. Likewise, with forward dollar-rupee contracts maturing there will be further drain on the liquidity. Also with advance tax payment in March, the liquidity is expected to tighten further. The Indian debt markets are also watchful of how the Government would be tread on the path of fiscal consolidation and what the Union Budget 2013 enunciates. If the budget 2013 is very populist, it may not send good signals to the Indian debt markets.

We have already seen most of the debt market rally happening in the past few weeks on expectation of 25 bps rate cut from the RBI in its stance of addressing to growth risk (as reflected by the slowdown in GDP growth rate). Now for yields to fall any further, aggressive rate cuts are required; which looks dim in the backdrop of macroeconomic assessment done by the central bank and the risk factors. It is noteworthy that any spill leading to higher borrowing estimates and deficit may lead to a negative sentiment and bond yields may see an upside shoot of 25bps to 30bps. We expect totally a 75 bps reduction in policy rates till December 2013 if inflation indeed mellows down and signs of moderation therein appear.

Hence we may not see a swift bond market rally as we witnessed in the recent past, but the conditions still looks lucrative to make decent gains in debt markets. Any intermediate rally will be short lived and hence one should not get carried away towards instruments having high interest rate sensitivity. The key will be to spread your bond portfolio across maturity. If you wish to play the interest rates, then you need to closely monitor the yield movement and take timely step to shift portfolio maturity.

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 month, 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 a little more 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 could 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 further. At present 1 year FDs are offering interest in the range of 7.40% - 9.00% p.a.

What should equity investors do?

At present in the month of February 2013, thus far the Indian equity markets are depicting a descending move, although the fall is petite -0.9% (as on February 13, 2013). The markets seem to be quite cautious and concerned over how the Government would address to the twin deficit problem (occurred by ballooning fiscal deficit and widening Current Account Deficit (CAD)), and how will they (Government) tread over the path of fiscal consolidation. Also the Union Budget 2013 (to be presented on February 28, 2013), would now be an event for the markets. Ahead of general election next year, if the budget is a populist one in the Government's attempt to win on vote banks, it may further put pressure on the fiscal deficit problem. On the other hand, if the Government raises taxes - especially the indirect ones, it may impede economic growth as consumption too may get affected. So it's going to be tight rope for the Finance Minister to walk on. The mood in the Indian equity markets at present remains submissive, with the Central Statistical Organisation (CSO) and the RBI projecting India’s growth for fiscal year 2012-13 at 5.0% and 5.5% respectively. While the finance ministry wants more banks to reduce lending rates in order to provide economic growth, some banks seem are desisting on doing so, citing high cost of funds (which has attributed to slower deposit growth). Moreover, such an action of reducing lending rates would be guided by what the RBI announces in the following policy meets depending upon the inflation data for the ensuing months. At present while the subsidy on diesel and most fertilizers has been increased and rates of non-subsidised Liquefied Petroleum Gas (LPG) too have been hiked in an effort to at least be closer to its fiscal deficit target, the repercussions could be inflations remaining over the comfort zone of RBI.

The FIIs thus far even in the month of February 2013 are exuding confidence in the Indian equity markets, by being net buyers to the tune of Rs 17,211 crore (as on February 08, 2013). With the U.S. fiscal deal being passed (by the U.S. Senate), confidence has been imbued in the global economy. Likewise although the long-term worries over the Euro zone debt crisis yet remain, the bailout package doled out for Greece and loan restructuring permitted for Spanish banks have infused some stabilisation, by putting the intermediate risk to rest. Also easy money policy adopted by the central bank of developed economies in support of growth, has helped FIIs to bet on developing economies. Having said that, they would keep a watch on the domestic macroeconomic risks, budget 2013, what reform measures the Government takes going forward and the political scenario ahead of 2014 general elections. Domestic mutual funds too would be attentive to such factors and accordingly tread their activity in the Indian equity markets.

Thus in the background of the above, we recommend investor to stagger their investments to mitigate risk, since the situation looks a little volatile. While investing in equity mutual funds, we recommend one to opt for the SIP (Systematic Investment Plan) mode of investing, as it will enable you to mitigate the volatility through rupee-cost averaging and power your portfolio with the benefit of compounding. However, while selecting mutual funds for your portfolio, prefer the diversified equity funds which follow strong investment processes and systems, and invest with a long-term horizon of at least 5 years.
 

What should investors in gold do?

Thus far in February 2013, gold prices in India have once depicted gains of +1.3%. With catalyst for gold once again getting evident, due downbeat domestic economic factors (such as slump in economic growth, lull in industrial activity, twin deficit problems, FDI not kick-starting despite reform measures taken) and global economic uncertainties (such as a contraction in U.S. Q4 economic growth rate to -0.1% and debt crisis in the Euro zone and contraction in economic growth there as well); smart investors are once again taking refuge under the precious yellow metal. Moreover, the paper money policy adopted by the central banks in the developed economy will have an effect of debasement of respective countries, which will support gold’s upward path. The higher gold prices are merely reflecting the diminishing purchasing power of the global fiat currencies.

At present, while the Government of India has raised the custom duty on import of gold to 6% in an attempt to curb gold imports, we think that would not impede the demand for gold in India and in fact buoy up import of gold through an illegal activity such as smuggling. Likewise while the RBI working group has recommended setting up of gold banks and and introduction of gold-backed financial products, we think the that too may not upset insatiable appetite of Indians to own gold and thus may not help in bringing down gold imports drastically.

So given the above backdrop where long-term economic problems still persist – especially in the developed economies, and now concerns over India’s fiscal deficit, economic growth rate and sovereign rating downgrade concerns yet lingering around; we think the ascending move for gold is intact over the long-term, because smart investors would view gold as a monetary asset rather than mere commodity.

At PersonalFN, we recommend that you should have a minimum of 10%-15% allocation to gold. Invest in gold with a long term perspective with a time horizon of 10 to 20 years.

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