Inflation on the rise
Inflation…on the rise
Inflation is not a strange word to the ears of Indian economy. In fact, till the early nineties India used to have double-digit inflation. In 1981 we had an inflation rate of 10.4 percent when GDP growth was over six percent. In 1991, it was as high as 13.1 when GDP growth was just one percent. But, since the mid-nineties, controlling inflation has become a priority for policy framers. While inflation, till the early nineties, was primarily caused by domestic factors (supply usually was unable to meet demand), but, today it is caused more by a lot of powerful global deflationary forces like the Sub-Prime Factor and Global commodity price rise etc.
Current Scenario…The rising Inflation, which is inching closer to 7%, is well above the Reserve Bank of India’s (RBI) comfort level of around 5%. Led by a sharp rise in the prices of metal and food products, inflation in India has moved up to 6.68%, after remaining close to 4 per cent in recent months, the highest ever in the past one year, dashing hopes of a softer interest rate regime in the near future.
Inflation is the rate at which the general level of prices for goods and services are rising, and, subsequently, purchasing power is falling. As inflation rises, every rupee will buy a smaller percentage of a good. For example, if the inflation rate is 4%, then a Re.1 pack of gum will cost Re.1.04 in a year. In simple words, when too much money chases fewer goods, it’s called Inflation, which is caused by the interaction of the supply of money with output and interest rates. Thus prices are increased so as to curb the rising demand. It affects all dimensions of the economy, right from interest rates to tax policies, consumer spending to business investment.
Piece of the cake…Suppose we have a simple economy. Every year our economy produces 10 pieces of cake. Let’s also say that there are exactly 100 rupees in the economy distributed evenly amongst 10 inhabitants of this economy. Thus, each cake piece will be worth 10 rupees and each inhabitant would buy 1 cake. If suddenly someone introduces 100 more rupees to the economy, then the price of each cake will be “inflated” to 20 rupees. Why? Say inhabitant A goes to buy his cake, but now he has 20 rupees, why not buy 2 pieces of cake? So inhabitant B sees this and doesn’t want to lose his piece of cake so he offers 11 rupees. At this price each can only buy 1 cake, but is left with 9 rupees in savings. Next year, each inhabitant has the 20 rupees plus the 9 rupees saved from the previous year. Inhabitant A will try, again to buy 2 pieces, but inhabitant B will, again, offer more…. can you see that this game will eventually lead to each paying 20 rupees per piece of cake?
If demand is growing faster than supply then prices will rise, Demand–Pull Inflation comes in picture, which is a common phenomenon in growing economies. When companies are running at full capacity and the cost of production increases, it results in Cost–Push Inflation. The high rates of inflation are also caused by high rates of growth of the money supply. The main reason of recent Inflation in India are rising crude oil prices, commodity price rise in the international market.
How does rising inflation affect the stock market?
At present, enormous amount of money is going out from equities. One of the reasons is Inflation in Asia, mainly originating from China, caused by the pressures on commodity prices. To control inflation, the central bank usually hikes interest rates. An increase in interest rate makes the present value of the future cash flows less valuable, as the present value is the reverse of compounding. It means that for some amount to be received in the future, its value should be lower today but inflation robs investors (and everyone else) by raising prices with no corresponding increase in value i.e. you pay more for less. That’s the reason, when the interest rate rises, bonds become attractive. This means company’s financials are over-stated by inflation because the numbers (revenue and earnings) rise with the rate of inflation in addition to any added value generated by the company.
However, high inflation is not always bad and low inflation is not always good for markets, as the impact differ for companies and sectors across different time horizons. The first thing to consider is the items where prices are rising like a rise in oil prices will impact a wide range of items from food products to those that require transportation.
How are companies affected by rising inflation…A rise in prices of several items means that the input prices for production of various goods and services are raising. In these cases one should always consider the net impact on the margin of the entity. While there might be an increase in the input prices, it has to be considered in the backdrop of the company’s ability to pass on the price hike to the end-user. If a company is able to sustain its profit margin despite high inflation, the stock price is likely to hold. If the high inflation sustains, at some stage it will lead to a chain reaction across the economy, pushing up interest rates and even affecting demand. An increase in interest rates will push up borrowing costs for corporate while lower demand will hurt growth in revenues. This is likely to impact sentiment for the stock market as a whole.
Inflation and your Investments…Stock market is the place to be when prices are rising. And it’s also the place to be when prices are falling! Because sometimes when sudden and unexpected inflation damages the stock, the same inflation, when constant, move the stock. While stocks are the best area to be invested in during times of inflation, growth stocks are best ignored when inflation does pick up because higher interest rates make their future earnings less alluring. Since most growth stocks trade on distant future earnings, it is best to stay away.
On the other side, Should you be concerned about inflation when your portfolio is consisting of fixed income securities? The answer is a definite yes. A rise in inflation is generally followed by a rise in interest rates. The total return (made up of the interest and price changes) on long-term bonds could go into even negative land due to rising interest rates. As we all know interest rates share an inverse relationship with bond prices, as interest rates go up, long-term bond prices fall. If you want to hold fixed income securities try to stay in very short-term bonds or in money market funds. Inflation erodes your purchasing power and the fixed income investor suffers when their investments buy less in each passing year.
Conclusion…
With rise in inflation, GDP growth is expected to decrease may be to 6-8% range. The food problem is the major factor in the inflationary pressures but at the same time, Indian agriculture sector is very attractive as here the arable land is close to 50% whereas in China it is 11%. With its demographics, India is likely to have two hundred million adult workforces in the next 20 years. If govt. hand over agriculture to the private sector, India can be the food basket for Asia.
Govt.’s steps to control Inflation may not change things much on the ground until global prices of oil, food and other commodities come down. All we can do is wait and see how the inflation and growth equations across the world pan out. It seems that global commodity prices would correct substantially as recession in the US becomes deeper. This is essentially based on historical trends, which show equity, and commodity prices always move in tandem. In the past two months, however, equity prices have fallen considerably and commodity prices have moved up. This divergence is seen as unnatural and it is expected that commodity prices would also correct downward. Moreover, history shows that high inflation rates could correct itself over a period of time through a combination of market forces and government regulation.
Managing your asset allocation is extremely important. It is a process, which needs to be reviewed at regular intervals, taking into account various factors like inflation. During Inflation, investors should keep an eye on interest-rate sensitive stocks. Go for inflation-indexed products like the Treasury Bonds and other products that offer a hedge against rising rates.
so where one should invest during the inflation?
One should invest in constant dividend paying companies with high book value