Although the RBI in its statements since the last policy meeting has indicated that there is unlikely to be further tightening in the near term the risks for the same remain mainly due to the significant rally in commodity prices over the last few weeks and also due to the fact that food prices have remained stubbornly high despite the good monsoon and a strong performance by the agricultural sector.
Yesterdays statement by the RBI governor stating that inflation is still above the comfort zone is discomforting with regards to their thinking on future policy action. The rupee also has started depreciating over the last few days in line with the rising risk aversion and the rally in the US Dollar. As such rupee appreciation is also unlikely to help to reduce inflationary pressures. The government and RBI’s target of inflation at around 6% by the end of March is in my view unlikely to be met given the cost pressures all around.
The critical factor as such becomes the stance of the Chinese who have refused to tighten to the extent they should given the real threat of Overheating in that economy. Recent figures of 27% auto sale growth, above 35% growth in both exports and imports clearly indicates an overheating economy in the backdrop of an increasing uncertain global economic outlook. All indicators of domestic demand growth continue to remain strong in China. Under the circumstances it is very likely that we might see greater Yuan appreciation and a series of increase in interest rates in China. This will also be essential to quell inflationary pressures in other emerging economies where the rise in commodity prices is largely due to two factors. The first obviously being the unbridled currency printing by the US Federal Reserve and the second being the behind the curve monetary policy in China.
A large number of commodities are today trading at all time highs or 30 year highs. This could be understandable for some agri commodities due to poor crops, weather etc. But the only explanation for such high prices in industrial commodities can only be financial speculation. A clear tightening stance by the Chinese will be required to make financial speculators sit up and reevaluate their positions.
Over the last 3-4 weeks we have seen one move up in the US Dollar followed by a correction. There seems to be atleast one more leg up (if not more) left for the USD and as that fructifies we could see that also lead to some sort of correction in commodities.
Under the circumstances, given that normally RBI has been hawkish on inflation a hike in policy rates on 16th of December should be the logical move. However given that the RBI also looks at the actions of other central banks in the immediate past before taking its own call the moves by Australia, New Zealand and South Korea to hold rates could make the RBI also hold on for the near term and take a call next month end.
Markets
The interesting phenomenon of the last 4-5 weeks has been the underperformance of Emerging Markets vis a vis Developed country markets. This has been an intriguing phenomenon as the main reason for uncertainty has been the Eurozone and that is where the maximum outperformance seems to be coming from. The only explanation I have for this phenomenon is that investors have been selling equities in economies facing inflationary issues and focusing on those where inflation is not an issue as liquidity will remain benign in such countries. Countries like India and China are likely to see a mid cycle slowdown and could underperform in the near term.
With the severe battering received by mid and small cap stocks over the last few days and the forced margin selling in a large number of stocks we should now see the underperformance of this segment coming to an end. Although markets could correct by another 5-8% the mid/small cap side of the market could outperform from here on as the capitulation seems to have happened on this side of the market.
