Inflation expectations in the United States, measured by the 5-year break-even inflation point, hit 2.94%, the highest level in 16 years. The persistence of a list of inflationary factors has led to a rise in core inflation and fuels the outlook for a potential wage-price spiral, especially when the labor market has tightened. The unemployment rate in the United States fell to 4.8% on September 21 from the post-pandemic peak of 16.5%, which is the biggest post-recession drop in 80 years.
Following these trends, central banks have now abandoned the often-repeated earlier perception of transient high inflation and are metamorphosing into a more hawkish stance. US Fed officials also admit that high inflation, which has climbed to 4-5 percent, will persist. The Bank of England is preparing markets for a faster and faster rate hike cycle. And several central banks like New Zealand, Norway, the Czech Republic and Russia have already initiated rate hikes.
Exceeding global inflation, especially in the United States and other advanced economies, could accelerate the normalization of monetary policy, tighten the risk-free rate and reduce excess global liquidity; These have been the quintessential drivers of global equity valuations since March 2020.
The IMF base scenario (October 21) assumes that inflation in advanced and emerging economies would remain pegged at 2% and 4%, respectively, by the end of 2022 and peak at 3.6% and 6.9 % by the end of the year. 2021. However, the risk is on the upside due to factors such as a) the persistence of supply bottlenecks, recently exacerbated by electricity shortages, b) the tightening of the labor market, c ) the emergence of adaptive adjustments for pipeline inflation, and d) the possibility of a potential lower COVID-19 GDP position.
Risking a hypothesis on the duration of the global energy shock is fraught with significant uncertainties. However, three inferences are worth highlighting.
First, the generalized surge in energy costs seems incompatible with the structural context of declining energy consumption especially since 2014, mainly in OECD countries. Second, the increase in global temperature anomalies since 2014 has implied warmer winters in OECD countries through 2019 and lower heating fuel consumption. In contrast, winters in Europe and the United States in 2020/21 were cooler and the La Nina effect may even return in 2021/22, supporting fuel demand in the near term. Third, we would like to believe that the abnormal surge in energy from post-Covid lows is due to friction factors, particularly in Europe and China.
So, in the base case, we see an energy shortage lasting 3 to 6 months (i.e. until April 2022), and believe that this would have an impact on the cost of production, as well as a reduction in supply in all sectors, due to the rationing of electricity, especially in China. This may prolong the existing constraints on the supply side for longer. The risk of cooler winters in the US and Europe, as well as negative elasticity with inventory levels (-4.2x) and limited supply from OPEC + can push Brent crude up to over 100 USD / bbl.
From India’s perspective, beyond the near-term decline in inflation, as the base effect wears off and we see the cumulative impact of rising inflation in costs, including fuel and electricity costs, improving pricing power and closing the gap between demand and consumption, this could imply a catching-up of inflation over the past 12 months. next month at 6.5-7 percent. Thus, contributing to a shift in the RBI’s stance towards overt normalization in addition to the impact of a higher Fed rate and stronger dollar. We expect the RBI to raise its key rates in 2022; the desirable real rate for India is around 1 percent, significantly higher than the current real rate of -2 percent. Therefore, there is also considerable scope for the standardization of policy rates.
Despite the recovery in demand after wave 2, the performance of Indian companies in the coming quarters would be affected by a) high material costs, b) higher crude oil and energy prices, c) l ” impact of the shortage of coal and electricity on the domestic market various industries, higher raw material and logistics costs and higher inflation on labor costs and d) shortages of supply of inputs / finished products imported from China, which is slowing down and experiencing a rationing of electricity. These will moderate future earnings expectations. Large firms with market power, service sectors and those competing with Chinese imports are likely to fare relatively better.
Rising crude prices generally have a positive impact on Indian stock valuations as long as they remain below USD 100 / bbl; this scenario is usually accompanied by better growth. But a stagflationary situation characterized by high inflation and lower growth has usually arisen once crude prices rise above $ 100 / bbl. That along with the tightening of the risk-free rate can trigger an inflection.
The risk for valuation is now high, both in historical and global comparison. a) The smart price / book at 4.3x is 20% higher than the 2010-19 average; The CY21 P / B at 3.6x is 24% higher than the average of the last 5 years. Futures valuations of Indian benchmarks are 70% higher than the average of the 23 major world indices and rank second richest after the United States. The relative valuation of small / large caps has declined somewhat from the July 21 peaks of 83 percent to 80 percent currently, but remains fairly high from the trend level of 65 percent.
We see a strong correlation between retail (and domestic) investments and valuations since the days of demonetization (2016). The contribution of the retail segment to market turnover rose from 39 percent to 65 percent at the peak. This is due to the banking sector’s excess liquidity emanating from an overly accommodating RBI, aggressive construction of unsterilized currencies and weak credit growth. Thus, the RBI’s LAF balance is currently high at INR 7 billion or 4.6% of bank deposits against the desirable level of 0.5%. The expected decline in the RBI’s foreign exchange reserve in response to the crumbling of the United States, the decline in FII flows and the widening of the CAD, the normalization of the RBI policy (stop of GSAP purchases) and the resumption of domestic credit growth would collectively reduce excess domestic liquidity in the coming months, leading to a valuation correction.