In the past two months, global markets have fallen substantially on inflation fears and central banks’ responses to the same. The inflation argument in India has been carried forward too far. In reality, inflation has little impact on the direction of stock markets. An analysis of the past 20 years’ history of the Indian market reveals there have been bear markets in periods of very low inflation and bull markets in periods of very high inflation. For example, the Japanese market had been in a bear phase for years, during times of zero interest rates and negative inflation. To understand the impact of inflation on markets, we have to understand why there are inflationary pressures. Inflation picks up where there is growth and declines when growth slows.
Today, when growth is picking up in Japan, the market is doing well and is expected to do well, as long as the economy expands, companies increase profits and consumers are confident. The era of very low inflation seems to be over globally. The faster central banks globally come to terms with this fact, the better it is for the global economy. This is because, contrary to the 1980s and 1990s — when growth in the world economy was not as widespread as it is today, and overall growth was driven by growth in the US, Europe or South-East Asian Tigers — today, there is growth all around. China and India have emerged as strong engines of growth. Other BRIC economies, as well as Middle East economies, are growing at 7%-plus. Growth in Europe has also picked up and Japan is growing after more than 15 years. Even Africa is growing at rapidly, driven by a commodity bull cycle. Such widespread growth will lead to inflation.
The second factor is that currently, there is very high inflation in metals, oil and agri-commodities. Agri-commodity inflation is mainly due to two reasons — firstly, growing prosperity worldwide is leading to increased consumption of food grains; secondly, diversion of products like palm oil, corn etc to bio-fuels production is creating a demand-supply gap in these products. It is unlikely that agri-commodity inflation will come down anytime soon. This is because, increasing production of agri-commodities is a long-term process; it involves increasing acreages and improving productivity, which cannot be done in a year or two. Monetary policy can do little to reduce agri-commodity inflation.
Under these circumstances, the response of central banks becomes critical. Under the current scenario, excessive monetary tightening may not reduce inflation significantly, but it can impact growth negatively, as costs for corporates rise and consumer demand is affected. The US Fed seems to be realising that excessive tightening can take the economy to recession, without bringing down inflation significantly. Over a period of time, as supply of various commodities increases, inflation will reduce to a certain extent. Moreover, the impact of monetary policy on demand is normally felt 18 months after the action.
In the current situation, when interest rates have already risen substantially over the past four years, a policy of status quo is desirable. Given the current interest rate scenario, economic growth in India is likely to slow down to around 8.2% for FY08. However, long-term growth prospects remain bright and the next 10-15 years should see average growth of 8-10%. Overall view on the equity market remains positive for both the medium and long term. The market is trading at valuations of 14.7x ’08E earnings on the large-cap side, while mid caps are trading at a substantial discount at 11.5-12x ’08E earnings. From these levels, the downside to the market looks limited. Over the next few days, the market can potentially move down by 6-7%. But from there, it should be able to give a return of 18-20% p.a. over the next three years.
The bull market may continue over the next few years. But the Indian market is now integrated with global markets. Global market movements, like that of May ’06 and February ’07, will affect the market in the short run, but in the long run, individual markets will perform on their own merits.
Originally By Sandip Sabharwal - CIO,JM Financial Mutual Fund.