Just after reaching the Reserve Bank of India’s comfort zone of below 7% in the month of March 2012, the headline inflation measured by the Wholesale Price Index (WPI), rose to 7.23% for the month of April 2012, dowsing hopes of a further rate cut. Moreover, the WPI inflation for the month of February 2012 was revised upwards to 7.36% from 6.95% as estimated earlier.

The main reason for the stickiness in the inflation can be attributed to the food inflation which came in at 10.49% for the month of April 2012 as against 9.94% in the previous month. The weightage of food articles in the overall WPI is 14.34%.
 

Inflation in an unstable mode!

(Source: Office of the Economic Advisor, PersonalFN Research)
Despite the drop in the Brent crude oil prices from $120 to around $111 the fuel & power inflation remained in the double digit terrain. For the month of April 2012, the fuel & power inflation (which has a weightage of 14.91% in the overall WPI) came in at 11.03% as against 10.41% in the previous month. However, considering the under recoveries of the Oil Marketing Companies (OMCs) we may see a further hike in fuel prices which may prove a dent to the prospects of inflation cooling down in the ensuing months.

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

The RBI will again find itself in a catch-22 situation where at one end it needs to propel growth (IIP for March 2012 slumped to -3.5%) and at the other tame the inflation bug which has again raised its ugly head above the 7% mark. If the policy rates are reduced by the RBI then this may give an impetus to the slowdown in the economy (as reflected in the subdued GDP growth of 6.1% in Q3 FY12) as the borrowing costs will reduce which will further help in bringing down the input costs as well. However, the supply side constraints need to be looked into as even though interest rates are reduced, the input costs may not be affected immediately due to lack of supply. Thus, the possibility of a rate cut seems negligible but the RBI may slash the cash reserve ratio (CRR) to ease the tight liquidity situation.
 

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	Unchanged	24.00%
Bank Rate	(50 bps)	9.00%

(Source: RBI website, PersonalFN Research)

 

Our View on inflation:

Going forward inflation numbers may harden further if the food inflation continues its northward movement. Though the crude oil prices have corrected a further fuel price hike may push the overall inflation numbers further northward.

What should equity investors do?

The Indian equity markets are resilient in nature and have potential for a robust future growth. Investors in equity should adopt calm and compose approach and stay invested from a long term point of view.

Moreover, the Indian equity markets are not completely de-coupled from the global markets and as such any negative news emanating from the developed countries may have a rippling and a crippling effect on the domestic markets. Moreover, with the Spain reporting a contraction in its economic growth (-0.3% for Q1 2012), signalling the confirmation of recession in one of the two large economies at the centre of the Euro zone's debt crisis and shrinkage in U.K.’s Q1 2012 GDP growth rate to -0.2%, indicates that the Euro zone is still not out of the woods. Moreover, with a new leader at its helm in the fifth largest economy in the world – France, the elite businessmen are having a second thought on carrying on their businesses in the country. This is because the France’s new President-elect Francois Hollande is planning to slap a 75% tax on income of more than Euro 1 million ($1.29 million), reinforcing the sentiment that in France to be rich is not glorious.

Hence taking a holistic view, the Indian equity markets is expected to undergo a phase of consolidation with a softer descending move, until the central bank does not resort to reducing policy rates further in order to impetus to economic growth. Moreover, the news disseminating from the developed economies would also pave the path for the Indian equity markets. Thus given an uncertain environment, we believe opting for the SIP (Systematic Investment Plan) mode of investing would be the right approach 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.

What should debt investors do?

Well, we think that the current situation is attractive to take exposure to debt mutual fund instruments as interest rates are likely to go down gradually over the months.

But it is not going to be an easy task for the RBI to reduce policy rates as it would have a challenge of keeping WPI inflation within its comfort zone after the April 2012 WPI inflation inching up the 7% mark. Moreover, with a possibility of fuel price hike looming large due to large scale under recoveries of Oil Marketing Companies and food inflation seen rising higher on account of fall in production of oilseeds in India, the headline inflation may remain sticky in the near future giving less room to the RBI to ease interest rates.

Hence at present while taking exposure to debt mutual funds and fixed income instruments, one should clearly know their investment time horizon. Since short-term rates are expected to fall due to liquidity concerns being addressed to, you can benefit from being invested in mutual funds having exposure to shorter maturity instruments. Hence 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.

If you have a longer time horizon then you can now gradually take 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 would continue to 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% - 9.25% p.a.

What should investors in gold do?

We may further witness 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. Any negative news may send a wave of shock and apprehension across the globe dampening the investment environment. Under such situation, investors are bound to take refuge to this precious yellow metal – gold.

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.

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