Inflation a bigger concern for markets than COVID

·Columnist
·4 min read

The markets in India closed on Monday, May 17, with the BSE Sensex rising a whopping 848 points to

49,580.73, while the NSE Nifty50 settled at 14,923 points, up 245.

Meanwhile, on the COVID-19 front, daily recoveries are now more than daily new cases and India seems to have hit the peak, as some experts had predicted, and will no see a drop in cases.

Further, the Indian government has made three important announcements which will increase vaccine availability and get the entire adult population inoculated by the year-end.

  • 2 billion (200 crore) doses of vaccines will be available between August to December.

  • Bharat Biotech and ICMR which hold the intellectual property rights jointly for Covaxin have agreed to share their formula of vaccines with other manufacturers to increase production.

  • The Government of India has accepted the recommendation for extension of the gap between the first and second doses of Covishield vaccine to from the present 6-8 weeks to 12-16 weeks.

With the government clearly focussing on localised lockdowns, the chances of a national lockdown have receded with recoveries exceeding new cases.

With these steps the risk to the markets from COVID-19 and vaccination-related news / events has reduced. The focus now shifts to inflation.

The United States’s markets tumbled for the first three days of the week before recovering on Thursday due to rising inflation fears.

Inflation data released on Wednesday showed the US consumer prices increased by the most in nearly 12 years in April 2021.

Consumer prices jumped by 4.2% in the 12 months through to April, up from 2.6% in March and marking the biggest increase since September 2008.

India’s retail inflation, measured by the Consumer Price Index (CPI), eased to 4.29% in the month of April versus 5.52% in March primarily on account of softening of the food prices.

The Wholesale Price Index (WPI) number for April will be released on May 17. In March, WPI rose to 7.39%, the highest in eight years since March 2013. The impact of WPI usually gets reflected in CPI with a lag effect.

The rising commodity prices globally coupled with a supply-side disruption caused by localized lockdowns poses upwards risk to inflation.

RBI Governor Shaktikant Das in his unscheduled address in early May said that the build-up in input price pressures across sectors, driven in part by elevated global commodity prices, remains a concern.

However, he added that the forecast of a normal monsoon by the India Meteorological Department is expected to sustain rural demand and overall output in 2021-22, while also having a soothing impact on inflation pressures.

RBI has cut repo rates by 250 basis points since February 2019 to provide financial stability in the economy and alleviate the post COVID-19 stress. It has held repo rates unchanged at 4% since August 2020.

RBI has kept the interest rates low to support the economic recovery and facilitate the government's huge borrowing plan in FY 2021-22.

The RBI has announced that it will raise the Cash Reserve Ratio from 3% to 4% by May 22, 2021. A hike in CRR will lead to reduction in liquidity available with banks which may force them to look out for more funds from retail depositors and an increase in interest offered on fixed deposits.

Both inflation and interest rates are two key macroeconomic variables that have a great impact on the economy in general and on the stock market in particular. If an economy experiences high inflation rates, then the real value of money declines which implies less purchasing power, less profitability and a reduction in the real returns on investments.

Moreover, an increase in interest rate results in higher expenses and less profitability. High interest rate signals to the market participants that investing in bonds rewards higher return than investing in equities, hence stock prices decrease.

For the stock market, high inflation is considered negative, as it impacts the return on equities.

CPI for April is within the band of 4%-6%. “Threshold inflation above which growth is unambiguously impaired ranges between 5% and 6% in India, indicating that an inflation rate of 6% is the appropriate upper tolerance limit for inflation target,” as per the RBI.

If the inflation remains consistently above 6% in India, it can be a cause of worry for the markets, as it could tilt the RBI towards raising interest rates.

Not only domestic inflation, investors also need to keenly watch the US inflation scenario. If the inflation rate in the US rises beyond a point, the interest rate may also have to rise sooner rather than later.

If that happens, a big chunk of the foreign money parked in the Indian share market and bonds may head to the US because investors can get a better return for lesser risk compared to an emerging economy like India, leading to markets tumbling here.

So, watch out for headline inflation numbers and keep this factor in mind while making investment decisions.

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