Inflation falls to 7.25%, a quick estimate not a real estimate

The Wholesale Price Index (WPI), which measures the headline inflation in the country for the month of June 2012, mellowed down to 7.25% from 7.55% in the previous month. However, such quick estimates are often subject to future revisions (most of the time an upward revision). The inflation for the months of January 2012, February 2012 and April 2012 were revised upwards to 7.23%, 7.56% and 7.50% from 6.89%, 7.36% and 7.23% respectively.

The graph below highlights the trend in the WPI inflation since June 2011. The inflation bug has been maintaining its stickiness despite efforts from the Reserve Bank of India (RBI) through its anti-inflationary stance. It is noteworthy that although inflation has mellowed down from its 9% mark seen in the previous fiscal, it is still high, above the RBI’s comfort zone of 6% to 7% which may preclude the central bank from taking any hawkish stance at its first quarter review of monetary policy 2012-13 (scheduled on July 31, 2012).

Inflation still above the comfort zone of RBI

(Source: Office of the Economic Advisor, PersonalFN Research)

The rise in headline inflation can be attributed to the following components, which constitute the WPI.

• Food inflation: With a weightage of 14.34%, the food inflation for the month of June 2012 stood at 10.81% as against 10.74% in the previous month. Going forward if the monsoon season results in subnormal rains due to the effect of an El Nino phenomenon in the second half of the monsoon season, it may further spur the food inflation.
  
  
• Fuel & Power inflation: The fuel & power inflation for the month of June 2012 stood at 10.27% as against 11.53% in the previous month. There were no revisions in the fuel prices during the month of June 2012. But, going forward if the diesel prices are decontrolled or raised in order to reduce the under-recoveries of the Oil Marketing Companies (OMCs) we may further see a steep rise in the fuel inflation.
  
  

Moreover, there is a threat to the country’s import bill as the Brent crude oil prices have again spiralled above $100 per barrel mark. But at the same time if the currency (Indian rupee) strengthens against the U.S. dollar, it might negate the adverse impact of rising Brent crude oil prices.

So, would RBI go in for a rate cut in the upcoming monetary policy review?

The Reserve Bank of India (RBI) may not go in for a steep rate cut despite the easing of the headline inflation to 7.25% for the month of June 2012. However, to soothe the industry pressing for a rate cut to revive the faltering economic growth, the RBI may reduce the policy rates by a mere 25 basis points (which may turn out to be a non-event).

Policy rate tracker

(Source: RBI website, PersonalFN Research)

Our View on inflation:

We think that going forward the chances of the WPI inflation heading northwards are higher owing to the fact that thus far monsoon this year is below normal. If at the end of the monsoon season, if indeed we have a sub normalcy it could further infuse upside risk for food inflation. Fuel prices too need to be watched for as any spike in the fuel price (diesel or petrol) can have a detrimental impact on the fuel & power inflation.

What should equity investors do?

Along with the banking crisis in Spain and Italy and rising borrowing cost thrusting pressure on the Government finances; the fears and the situation of debt-overhang in the Euro zone are very much alive. It is noteworthy that, the entire Euro zone at present is reporting dismal economic growth despite interest rates being placed low by the European Central Bank (ECB). Recently in order to tackle the Euro crisis, the ECB reduced policy rates to 0.75% (from 1.0%) - in line with the expectation, but this move now is likely to weaken the Euro against all major currencies and cannot be seen as a permanent remedy for the Euro zone crisis.

The manufacturing sector in the U.S. reported shrinkage for the month gone by (i.e. June 2012) for the first time in the last three years, as new orders have tumbled due to gloom clouds surrounding the global economy. The Index of National Factory Activity for June 2012 (data released in July 2012) has fallen to 49.7 from 53.5 in the month before, thereby missing expectations of 52.0. It is the first time since July 2009 that the index has fallen below the 50.0 mark (which demarcates expansion and contraction), and thus it seems that economic recovery is impeded and fragile.

As far as India is concerned, along with the global economic headwinds looming around, the domestic economic and political environment is playing a spoil sport. While, all eyes are now are on the RBI to cut rates (in the environment where global central banks have cut rates) and provide impetus to economic growth, the stiff WPI inflation may hinder aggressive rate cuts from the India’s central bank.

Hence taking a holistic view, although the Indian equity markets would remain susceptible to news disseminating from the developed economies, they are likely to perform better with likely chance of better foreign flows from the developed due near to zero interest rate regime. Moreover now with Dr. Manmohan Singh now at the helm of the finance ministry, renewed confidence could be exuded, as the Government may work towards achieving political consensus to ensure that the reform measure aren’t stuck. But given that markets may continue to remain volatile in the backdrop of the global economic headwinds, Q1FY13 earnings and other economic factors; we recommend one to opt for the SIP (Systematic Investment Plan) mode of investing, as it will enable you to mitigate the volatility through rupee-cost averaging and power your portfolio with the benefit of compounding. However, while selecting mutual funds for your portfolio prefer the diversified equity funds (preferably which adopt value style of investing or the opportunities style of investing) which follow strong investment processes and systems, and invest with a long-term horizon of at least 5 years.

But when investing in mutual funds it is vital to select only those equity mutual funds which follow strong investment processes and systems, and invest with a long-term horizon of at least 5 years.

What should debt investors do?

Well, we think that the current situation is attractive to take exposure to debt mutual fund instruments as interest rates are likely to go down gradually over the months.

Hence at present while taking exposure to debt mutual funds and fixed income instruments, one should clearly know their investment time horizon. Investors with an extreme short-term time horizon (of less than 3 months) would be better-off investing in liquid funds for the next 1 month or liquid plus funds for next 3 to 6 months horizon. However, investors with a short to medium term investment horizon (of 1 to 2 years) may allocate a part of their investments to short-term income funds which should be held strictly with at least 1 year time horizon.

The present scenario also seems comfortable to look at longer horizon debt mutual funds. Thus, if you have a longer time horizon, then you can now hold some exposure to pure income funds. Since longer tenor papers will become attractive, longer duration funds (preferably through dynamic bond / flexi-debt funds) can be considered, if one has an investment horizon of say 2 to 3 years. However, one may witness some volatility in the near term as there is always an interest rate risk associated with longer maturity instruments.

Fixed Maturity Plans (FMPs) of upto 1 year may for some more time yield appealing returns and can also be considered as an option to bank FDs only if you are willing to hold it till maturity. You can consider investing your money in Fixed Deposits (FDs) as well, before the interest rates offered on them are reduced. At present 1 year FDs are offering interest in the range of 7.25% - 9.25% p.a.

What should investors in gold do?

Even at the present price range, gold still can be considered as your hedge against the spiralling inflation. Though there will be some sideways movements due to any temporary relief in the paining Euro nations, we believe that there could be volatility in the equity markets if the paining Euro nations like Greece, Italy and Spain do not come with some concrete solutions to get their finances in place. Also, with the Government battling to meet the fiscal deficit target amid a gloomy global economic scenario and a slowdown in economic growth, we think that investors would prefer to take refuge under the precious yellow metal despite elevated prices.

Hence, nothing has changed for gold and we believe it will continue to maintain its upward trend in the long-term along with some sideways movement too.

At Personal FN, we recommend that you should have a minimum of 5%-10% allocation to gold. Invest in gold with a long term perspective with a time horizon of 10 to 20 years.