Stock Markets and commodities – Inflationary effets

They say whatever goes up must come down. The law of inflation, however, works differently, whatever goes up will go up some more. But whenever inflation is mentioned, the markets promptly obey the law of gravity and fall. Recently we’ve seen a fair bit, and investors are very worried is the anxiety warranted? Or do the dark clouds of inflation have a silver lining?

There’s no doubt that inflation is an investor’s worst enemy. Equity investors lose as companies borrowing costs rise, credit becomes tight, and margins are squeezed. Debt investors see real estates (interest rate minus inflation) decline and bond values fall. The non-investing public and politicians too, dread inflation. It is public number one. So it is to assume that rising inflation is a threat to the broad structural rally in Indian stock markets? Actually it’s not possible to draw a close and direct connection between inflation and the Sensex in the short term. Inflation will have an impact only over the long term. Looking at wholesalers price index-based inflation data over the past eight years, we find that although inflation has been relatively benign in recent years, it shot above 8% (which is higher than what we’re seeing now) in 2004, and stayed above 6% for nearly six months. How did that affect stocks? Well, the Sensex gained almost 35% in six months without even stopping for breath. There is one important difference now: inflation is higher at the consumer level today. Is this difference important enough to bring the market down?

If inflation persists, it can be a threat. And it will persist if process move higher consistently, or if expectations of inflation get baked into the economy. In the first scenario, process must keep rising, and not just stay high, for inflation to persist. If they stayed high but stopped rising inflation would drop to 0% after a year, because of the higher base effect. In the second scenario, people start demanding higher wages and prices due to inflationary expectations. This it self pushes up costs in the economy giving inflation a leg up. In this case, inflation would persist for a few years, until expectations of inflation are controlled by policy action.

The current bout of price increases is because of shortage due to inclement weather and international process firming up due to a weak dollar. Take the case of wheat – a drop in output in Australia led to higher process. In the case of metals and so on, the weak US dollar pushed process higher. Investment in commodity funds has fuelled the rise. While all these factors may keep prices on the boil for some months the critical issue is: will prices keep rising over the long term? If inflation comes under control within a few months, then this blip will have no lasting impact on stock prices. So the net question is: how long can prices can move higher?

Although the government is doing all it an to stem inflation through price controls and storage restrictions, hoarding is likely to continue. But the price signals should spur supply in the coming months. Prices may not go down to previous levels, but incremental supply should rain in runaway prices. International prices have already dipped from recent peaks. While crude oil and metals are still near recent peaks, many other commodities have dropped significantly. Wheat is down 40% from its end February peak, Sugar coffee and cotton are down 20-25%, in the same period. Soya-bean oil is down 15%. These could be just bull market corrections which means prices may rebound, but the pace of increase will be moderated, and it will automatically contain inflation through a base effect over the next few quarters.

Another factor to watch will be the US dollar. A weak dollar could keep commodity prices high, but rebound could help contain process. The curtailing of credit by US banks are disinflationary factors. This could strengthen the dollar in the coming months. Most people believe the Fed is near the end of its rate cutting cycle, lending further support to the dollar. Any signs of easing in commodity process could also nudge the Euro zone to ease monetary policy, further helping the dollar.

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