RBI – Wrong prescription & diagnosis, results & markets

For the second time in three months RBI’s monetary policy announcement has led to a breakdown in the build up of a positive trend in the markets. A 25 basis points increase would have led to the continuation of the rally and we should have seen markets at around 6000/6100 for the Nifty by August end and this was my view for the last few weeks. However the negative sentiments generated by the RBI policy is likely to shift the target by around a month further as the markets readjust to the new reality and take into account a further squeeze in profits due to higher interest costs.

RBI with the recent hike has increased interest rates by 125 basis points in just three months. (Incidentally this is the overall tightening that China has done over the last one year). In the few days prior to the policy announcement by the RBI we saw several central banks like those of Korea, Israel, Indonesia etc hold rates citing European and US debt concerns and slowing global growth. However RBI obviously believes that India is a country that is insulated from the rest of the world and operates in isolation and as such global factors need to be ignored. This is the same stance that the previous RBI governor had taken in the second half of 2008 which led to a severe disruption in economic activity over a period of nearly 6-9 months. I think the central bank has operated similar to that of a frustrated investor who after waiting for months finally decides to throw in the towel at the absolute bottom of the cycle.

The fact of the matter is that it is the global commodity cycle up move which has caused inflation in India to spiral. One of the logic given to increase rates is increasing core inflation. However as I have argued before the pass through of an abnormal increase in input costs is but natural. However even then a 7% core inflation in a scenario where lots of commodities have rallied nearly 50-100% over the last one year is quite reasonable. How can manufacturing inflation be taken in isolation to the input price increases. In any case we are today at the mercy of arm chair economists and it is becoming difficult to predict their future moves.

One of the surprising things that came out in the policy was the frustration of RBI with government inaction on improving the supply situation as well as bottlenecks in the same. In a way they have stated that we are alone in this fight now and under the circumstances we have no option but to try to curtail demand severely and hope that it will control inflation. However the reality remains that RBI can do little to control inflation that is driven by global commodities and rising food prices.

If the target for inflation by March end is still 7% then that is something that will be achieved just by the base effect. As such they seem to have actually given up hope of their policies having any effect.

The fact is that higher rates at a time of policy paralysis will have two effects. One will be that further capacity additions across segments will come down as money becomes more expensive and this will further feed inflation into the system. Secondly the cost of borrowing of the government will go up and along with it the indirect tax collections will come down (due to slower demand growth) and corporate tax collections will come down (due to lower profitability). Moreover the denominator for the calculation of Fiscal deficit will come down as GDP growth will be lower. As such this could create an upward bias on the direction of the Fiscal Deficit.

The last few days we have seen several developments on the global scene where we have seen that the Euro zone has acted with speed in order to contain the contagion effect of Greece and seem to have been successful in the short to medium term. However the US Debt ceiling and Fiscal Deficit issues continue and have been affecting the global markets negatively over the last few sessions. Ultimately there will certainly be an increase in the US Debt ceiling; however the key is the future fiscal deficit of that country and the deficit reduction. For this fiscal year the US will have a deficit of around 10% of GDP and the US Fed has injected liquidity of around 5% of GDP through QE2. Despite such a huge stimulus we have not seen any appreciable improvement in the economic activity as most of the excess money has gone into commodity speculation. Under the circumstances, given the fact that the US Banking system is now reasonably healthy and corporates in the US are doing well it will be important to now act on cutting the fiscal deficit. A downgrade in rating can set up a spiral of increasing borrowing costs for the US that it will be able to ill afford in the long run. The fact of the matter is that they need to cut spending and increase taxes.

MARKETS

Overall the results season has been mixed with divergent results. The good part about the results has been that in the financial sector the NPAs seem to be under control and this is absolutely essential in a phase of increasing interest rates. The key will be to see how they behave over the next 3-6 months. The IT sector has given good results and the outlook seems to be positive. Telecom as a sector seems to be bottoming out and the financials should bottom out sometime during the current quarter as inflation tops out. On an overall basis after doing a company by company analysis it seems to be clear that the level of 5200 for the Nifty seems to be a clear bottom which will not be breached unless and until we have a catastrophic event or an unprecedented sell off in global equities. As such the downside to the markets seems to be limited.

However given the tight liquidity scenario and the slowing investment cycle the upside also seems to be limited near term as the markets adjust to the new interest rat environment. Decision making on the policy front and clearance of projects, lesser delays and reform measures as such become important to take the markets out of its range bound trading. Ultimately we should break on the upside, however when is the question now. It could now be only later in the year. Inflation should start easing over the next two months and that could be the trigger for the up move. In the meantime we could again see defensives outperform despite them trading at extremely high valuations.

On the other hand August could actually be a month of hardly any negative news flow and inflation data for July could also surprise on the downside as there was a spike up last July. It’s a time of glorious uncertainties and it will be a good time to pick up the stocks one likes and has belief in and hold on for the rally which will eventually unfold.

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