The WPI inflation for the month of October 2012 eased marginally to 7.45% from 7.81% in the previous month. However, stickiness still seemed evident with inflation plateauing around the 7.00% plus mark for the last eleven months, and also with series of upward revisions in the earlier months. (See chart below)
 

Inflation mellows, but stickiness evident!

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

The marginal drop in the headline inflation was mainly attributed by the following components of the WPI, which eased:

Fuel & Power inflation: Despite the hike in fuel price in November 2012, fuel and power inflation dropped marginally (by 18 basis points) to 11.71% from 11.88% in September 2012. But a noteworthy point is that stickiness and volatility still seemed evident in this component.

Even going forward, with the indirect effect in fuel price revision (wherein prices of diesel has been raised by Rs 5 per litre and non-subsidised LPG has become dearer), we could see this component of the WPI depicting an upward bias. While Brent crude oil prices are seen easing due to dismal global economic growth, we think the impact of Sandy storm in the U.S. is likely to stoke-up oil prices. Also with the Indian rupee depreciating once again, the ease in oil prices could be cascaded by the depreciating Indian rupee, which in turn could also be detrimental for India's current account deficit. Thus far, the slew of reform measures taken by the Government haven't been able to bring any respite to the movement of the Indian rupee, because while measures are taken, important bills are yet to be passed in the winter session of the Parliament. And given the present political backlash and opposition flagging their ideologies on respective reform measures, there are likely chances that Parliament proceedings during the winter session may get disrupted due to objections raised by the opposition parties.

Food inflation: Food inflation (which has a weightage of 14.34% in the WPI), for the month of October 2012 also reduced (by 124 bps) to 6.62% from 7.86% in September 2012, seemingly because of the positive impact of a good monsoon which led to a decent agricultural produce.

This led to prices of primary articles also lower to 8.21% from 8.77% in September 2012. Within the food basket, potato prices came down 3.2% last month triggering a larger contraction in overall vegetable prices.

But going forward, the increase in diesel prices along with a trickling effect of high freight charges are likely to put pressure on food inflation as well. This is because diesel is an essential transport and industrial fuel, and the rise in the same may have a broader impact on WPI inflation. Moreover, it is noteworthy that data for food inflation has also seen an upward revision in the past few months, which also indicative of pressure on food inflation as well.

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

Given a scenario where in the intermediate inflationary pressures could still persist due to fuel price increase initiated by the Government, WPI inflation is likely to plateau around 7.00% plus mark for ensuing some months. This in our view may preclude the Reserve Bank of India (RBI) from reducing its policy rates in its 3rd quarter mid-review of monetary policy 2012-13 (scheduled on December 18, 2012), since the WPI inflation continues to remain over the comfort zone of RBI.

The central bank would be watchful of the WPI inflation data, and if it indeed mellows down below the comfort zone (of 6.0% to 7.0%), we could see rate cut only in the first quarter of new calendar year.
 

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)

 

The RBI in its 2nd quarter review of monetary policy has perceived inflationary pressures persists along with risk from twin deficits i.e. current account deficit and fiscal deficit. Thus assessing host of macro-economic factors, the RBI's stance of policy will be conditioned by careful and continuous monitoring of:
 

• Evolving growth-inflation dynamics;
• Management of liquidity conditions (to ensure adequate flows of credit to productive sectors); and
• Appropriate responses to shocks emanating from external developments.
   

Our View on inflation:

As mentioned earlier, we see inflationary pressures to persist due to increased prices of fuel and freight charges, which may trickle down to food items as well. Thus for about a couple of months, we see WPI inflation plateauing around the 7.00% plus mark.

What should equity investors do?

In our view, with slew of reform measures taken by the Government, economic growth could be propelled. However, the winter session of the parliament would be very crucial this year, because there are several important bills which are awaiting clearance (such as the FDI in multi-brand retail, Pension Bill, Insurance Bill, Real Estate (regulation & development) Bill), which can put India on the growth path. With an uncertain political environment and the tainted political canvas with graft charges on the Government in power and the opposition, risk does persist when every political party is trying to flag their ideologies over critical reforms. So reforms can put India once again on a growth path, but what's vital is sanctity and consensus in doing so.

In order to stave off a fiscal crisis, Finance Minister - Mr P. Chidambaram, has asked his ministerial colleagues to take belt tightening measures, but how it indeed transpires need to be seen.

The global economy is filled with gloom. While Mr Barack Obama has been victorious and re-elected as the U.S. President, his success in managing the fiscal situation will guide the equity markets, as the economic data of world's largest economy would have a rippling effect. In the Euro zone, the debt-overhang situation is now causing even Germany to sputter, as their industrial output too fell by a hefty 1.8% in September 2012, more than the consensus forecast of 0.5% in Reuter's poll. The economist forecast (of 0.8% for this year and next) from their Government's economic advisor have also dampened the spirit , and is giving indication that even the stronger nations in the Euro zone are now reeling under pressure.

Thus in the backdrop of the global economic and political environment we flag concerns of risk inducement, and therefore recommend investors 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 debt investors do?

Looking at the growth-inflation dynamics, interest rates are likely to hover around the present elevated levels, until signs are moderation in WPI inflation are evident.

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 1½ 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% - 8.90% p.a.

What should investors in gold do?

With inflationary pressures yet evident we see gold continue to display it lustre, as it holds a trait of being a hedge against inflation. The physical demand during festive season and wedding season is also likely to be supportive for the precious yellow metal. It is noteworthy that traditionally, the demand for gold in India (world's top consumer of gold) rises in the last quarter of the calendar year, and this cyclicality could push gold prices further northwards.

Also the risk-event period is supportive for gold. With uncertainty looming around due to the U.S. fiscal cliff and the debt-overhang situation in the Euro zone - where now even some of the stronger nations therein are feeling the pain; the precious yellow would continue to enjoy its place of being a safe haven and smart investors would continue buying gold. At present with Mr Barack Obama being re-elected as the U.S. President, could be positive for gold as it means quantitative easing is set to continue along with protraction of unconventional policy measures (which could drag the U.S. on the fiscal front). Also with the ECB too maintaining rates at their historic low of 0.75%, looks positive for gold in the backdrop of debt crisis prevailing there.

So, given the above backdrop where long-term economic problems still persist - especially in the developed economies, we think the ascending move for gold is intact. Also the ascending move would be well supported if festive demand indeed picks up. Hence in this context GETFs would continue to do well, due to positive impact on gold prices.

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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