Contrary to the expectations, WPI inflation for the month of December 2012 dropped to 7.18% from 7.24% recorded a month prior. WPI inflation for October 2012 revealed a downward revision, and thus after numerous upwards revisions, there seemed to be some signs of moderation evident.
 

WPI Inflation eases further

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

The drop in WPI inflation for December 2012 can 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 5.04% in December 2012 from 5.41% a month prior.

Fuel & Power inflation:
Likewise fuel and power inflation (which has 14.91% in WPI) also descended noticeably to 9.38% in December 2012 from 10.02% as seen in November 2012. The corrective phase undergone by global crude oil prices also helped this segment of WPI clubbed with 95 paise reduction in petrol prices brought in by the Government in mid-November 2012.

Food inflation:
However food articles (which have a weightage of 14.34% in WPI) continued to depict inflationary pressure as it rose to 11.16% in December 2012 from 8.50% as seen in November 2012. It snapped the trend of price moderation (on month on month basis) in food articles observed over last few months; this therefore exacerbated the monthly price pressures in this segment.

Thus it can be said that rising cost of food articles had a cascading effect to moderation in prices seen in manufactured goods and easing fuel & power cost. Hence, as a result the drop in WPI inflation for December 2012, as against the previous month was just 6 basis points, thereby yet keeping WPI inflation over the comfort zone of RBI, although signs of moderation are seen.

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

The WPI inflation for December 2012 is much lower than 8.00% projection made by the Reserve Bank of India (RBI) in its 2nd quarter review of monetary policy 2012-13 (held on October 30, 2012). The moderation in overall headline inflation may thus encourage the central bank to show consideration for growth. In the last guidance from monetary policy (i.e. as enunciated in the 3rd quarter mid-review monetary policy 2012-13), the RBI has already said that decline in core inflation has been comforting and in the view of ebbing inflationary pressures, the monetary policy stance would increasingly shift focus and respond to the threats to growth.

The RBI we think, would view the Index of Industrial Production (IIP) data very closely as the trend thereto has been rather ‘see-saw’ and for the month of November 2012 there’s been a sharp contraction (to -0.1%). This may encourage RBI to reduce policy rates at least by 25 bps (0.25%), and anything in excess of would protract the current rally in Government securities.

It is noteworthy that the liquidity deficit in the system and expectation to see a rate cut by RBI has given rise to investment opportunities at both the ends of the yield curve, where long-term debt funds are likely to perform better. However the Indian debt markets would be careful over what the Finance Minister’s Budget 2013 budget speech pronounces. If the Budget 2013 is populist, the Indian debt markets may witness upticks in yields once again, since such a budget would put further pressures on India’s fiscal deficit.
 

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	(50 bps)	4.25%
Statutory Liquidity Ratio	(100 bps)	23.00%
Bank Rate	(50 bps)	9.00%

(Source: RBI website, PersonalFN Research)

 

Our View on inflation:

Although the trend of a moderation in WPI inflation may continue due to softer crude oil prices at present and other commodity prices remain lower; the weakening of the Indian rupee may seep in stickiness in WPI inflation. Furthermore in 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% plus mark.

What strategy debt investors adopt?

In the backdrop of what is expected from the RBI (as a result of moderation in WPI inflation and contraction in IIP in November 2012 as mentioned above), 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 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 7.50% - 9.00% p.a.

What should equity investors do?

Going forward, it remains to be seen whether FIIs would continue to exude confidence in 2013 as well, because India’s current account deficit is widening (it was at a record high of 5.4% of GDP in the September 2012 quarter) and fiscal deficit could also fail to achieve the target of 5.3% GDP; although the Government is quite ambitious on its path of fiscal consolidation. Due to ballooning deficit, rating agencies have warned of axing India’s sovereign ratings and if this situation continues or worsens, it would not be too long before they rate India as "junk". Stating that the Government is likely to miss its fiscal deficit target for the current financial year, rating agency Fitch said India may face a credit ratings downgrade in the next 12-24 months. Standard & Poor's had also warned that India still faced one-in-three chance of downgrade in its sovereign rating to junk grade over the next 24 months citing high fiscal deficit and debt burden. "A downgrade is likely if India's economic growth prospects dim, its external position deteriorates, its political climate worsens, or fiscal reforms slow," the S&P had said in a statement.

It is noteworthy that India is encountering a slowdown in economic growth rate due to negative ripples seen earlier from the global economy and to near to high policy rates seen so far. The recent IIP data for November 2012 at -0.1%, has proved that October 2012’s sharp impulse was a mere positive statistical effect and to an extent supported by festive season.

At present the global sentiments are conducive for the markets. With the U.S. Senate approving the last minute deal to avert a fiscal cliff, confidence has been imbued into the global economy. The Senate passed the legislation, which would make taxes remain steady for the middle class and rise at incomes over U.S. $4,00,000 for individuals and U.S. $4,50,000 for couples - levels higher than President Barack Obama had campaigned for in his successful drive for a second term in office. As far as spending cuts are concerned, they are totalled at U.S. $42 billion over two months. In the Euro zone too with bailout package doled out for Greece (€40 billion, aimed at bringing an immediate 20% reduction to the country's debt) and Spanish bank loans restructuring approved (expected to inject around €37 billion into the Euro zone), worries over the Euro zone debt crisis too have receded for the time being. China too is showing signs of economic recovery with better manufacturing data (HSBC China manufacturing Purchasing Managers' Index rose to a final reading of 51.5, an upward revision from the preliminary 50.9 result) being reported due to news business flows. FIIs have exuded confidence thus far into our equity markets by being net buyers to the tune of Rs 5,772 crore (until January 07, 2013), and the BSE Sensex too has ascended by about 1.4% since the beginning of the new calendar year.

But we think, hereon the markets would be watchful of:
 

• Political scenario in India (ahead of 2014 general elections)
• Ballooning fiscal deficit
• Widening CAD
• Manufacturing data
• Services sector growth
• Economic growth rate
   

While the Government may make an attempt to pronounce a populist Union Budget 2013 and try to elevate sentiments, it could in the long-term be damaging for our fiscal position. Also with recovery in China, FIIs may not shy away from turning their focus on Chinese equity markets. Moreover recovery in China could also stoke-up commodity prices leading to inflation in India.

Thus in the background of the above, we recommend investor to stagger their investments to mitigate risk. While in 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?

Going forward, with risk event yet remain on the domestic front such as ballooning fiscal deficit, widening current account deficit, weak Indian rupee, slowdown in economic growth rate and chances of sovereign rating downgrade for India, we think prices are likely to stabilize. Moreover, the rise in demand due to on-going wedding season is likely to enable prices to linger at elevated levels. Also with most central banks increasing their gold reserves, not forgetting that risk to the global economy yet remain; demand seems to broad and global phenomenon. Also since most central banks are adopting easy monetary policy (to handle the economic slowdown and their fiscal situation), it is supportive for gold. The idea in the western economies of printing more currency (for it to be used as reserve currency) to solve their sovereign debt crisis seems to be inflict more long-term problems such as devaluation of currency and inflation, for the developed economies and thus may act a catalyst for long-term trend in gold to remain intact. In the Euro zone although fears have receded, the economic tensions haven’t reduced and thus it may not be very long before we witness fresh crisis from the Euro zone. In the U.S. too, they have raised their debt ceiling limit several times and thus their debt-to-GDP ratio has stepped up, which remains a concern although the U.S. Senate has passed the fiscal deal.

It is noteworthy that supported by easy monetary policy, there are beliefs that there could be a smart economic recovery, which would reduce the demand for the precious yellow metal. But we believe that then inflationary pressure would creep in and current devaluation may occur leading to smart investors continue to take refuge under the precious yellow for its trait of being safe haven. Intermediate corrective phases in gold may encourage investors to binge on gold.

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 and sovereign rating are 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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