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Fear not, this inflation spike will pass

02/07/2021
India
Equities
Fixed Income

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Summary

  • The wholesale price index recorded an increase of 13 per cent in May, more than double the second highest point in the past five years. Consumer price inflation has also broken through six per cent – the upper limit of the Reserve Bank of India’s inflation targeting corridor
  • In our opinion, the current spike in inflation is due to supply-side disruptions and so will not persist
  • India is the only major Asian economy seeing wholesale price inflation spilling over to consumer price inflation, due to the large makeup of ‘food and beverages’ in the CPI index and the impact of rapidly rising crude oil prices
  • Even if we’re wrong, inflation has not historically been a drag on asset prices

Talks of inflation are flaring up everywhere. After US President Biden announced his $1.9 trillion stimulus plan earlier this year, investors brought their inflation worries to the US bond market, pushing the ten-year treasury yield from below one per cent all the way up to 1.7 per cent at one point. Of course, Asia is not immune to inflation fears. While we believe that worries of protracted inflation in other major Asian countries such as China are unfounded – as we have extensively commented in this month’s issue of China Insights – the situation with India might be more complex and calls for a different angle of analysis. Let us dive right in and explore whether the current inflation spike might pose a problem to India’s capital markets.

An spike in inflation

The inflation numbers for May have not allowed people keen on the Indian economy a sigh of relief. The wholesale price index recorded an increase of 13 per cent, more than double the second highest point in the past five years (Figure 1). Consumer price inflation has also broken through six per cent – the upper limit of RBI’s inflation targeting corridor.

This untimely surge could partially be attributed to a low base effect from last year, but also has to do with surging commodity prices. Figures 2 and 3 show the inflation numbers for individual components of the CPI and WPI indices respectively. It is clear that higher fuel prices as of late have contributed to the recent inflation spike. Higher-than-usual food price inflation also does not help. The question is: is this a structural or transitory development?

Source: Bloomberg, data as of June 2021

Investment involves risks. Past performance is not indicative of future performance. For illustrative purpose only. The views expressed above were held at the time of preparation and are subject to change without notice. The information provided does not constitute any investment recommendation in the above mentioned asset classes, indices or currencies.

This commentary provides a high level overview of the recent economic environment, and is for information purposes only. It is a marketing communication and does not constitute investment advice or a recommendation to any reader of this content to buy or sell investments nor should it be regarded as investment research. It has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is not subject to any prohibition on dealing ahead of its dissemination. The performance figures displayed in the document relate to the past and past performance should not be seen as an indication of future returns. Any forecast, projection or target where provided is indicative only and is not guaranteed in any way. HSBC Asset Management accepts no liability for any failure to meet such forecast, projection or target. 

Source: Ministry of Statistics and Programme Implementation, data as of June 2021

Source: Ministry of Commerce and Industry, data as of June 2021

A strong recovering demand? Or temporary disruptions to the supply chain?

Whether you believe inflation will be a structural problem or just a transitory one boils down to which one of the following two explanations for the current surge in prices you buy into. Is it a strong recovering aggregate demand chasing after produced goods? Or just temporary disruptions to the supply chain putting a cap on output? Demand-driven inflation tends to persist until supply capacity catches up over time. On the other hand, if inflation is caused by disruptions to the supply chain, it would revert back to normal once the disruptions are gone. We believe the supply-side explanation is a more accurate depiction of the present-day situation.

Because of supply chain disruptions, most Asian countries are experiencing a spike in their producer/wholesales prices, but India is the only major economy in the region seeing wholesales price inflation spilling over to consumer prices. A major factor is that ‘food and beverages’ constitute more than half of the India CPI index. Food and beverages are essential goods, so producers and wholesalers would find it easier to pass production cost increases on to customers. Another reason is that although ‘fuel and light’ only make up about eight per cent of the CPI index, the sharp rise in crude oil price this year still manages to make an impact on the overall price level.

Impact on equities and bonds

Historically, how did realised inflation affect asset prices? Figures 4 and 5 plot India’s CPI inflation against the Nifty 50 index’s monthly return and the ten-year government bond yield respectively, over the past half-decade. In the case of equities, there is no discernible linkage between the two, which shared a correlation of only 0.1. Surprisingly, the correlation between inflation and the ten-year government bond yield was minus 0.4 over the past five years, suggesting that higher inflation goes hand in hand with higher bond prices. This is due at least partially to the government’s monetary agenda to keep long-end rates low. In short, inflation occurring in the recent past had not been a drag on asset prices.

Source: Bloomberg, data as of June 2021

Source: Bloomberg, data as of June 2021

Investment involves risks. Past performance is not indicative of future performance. For illustrative purpose only. The views expressed above were held at the time of preparation and are subject to change without notice. The information provided does not constitute any investment recommendation in the above mentioned asset classes, indices or currencies.

Fixed income

Source: Bloomberg, data as of June 2021

Source: Bloomberg, HSBC Global Asset Management, as of June 2021

Government bond yields remained largely flat with both five-year and ten-year closing the month unchanged, at 5.6 and 6.0 respectively. The segment beyond ten years has widened by about 3 to 4 basis points. Yields in the belly and the long end of the curve have been suppressed by a series of open market operations under the Government Security Acquisition Programme and “Operation Twist”. The announcement of GSAP 2.0 – amounting to 1.2 trillion rupees and to be implemented in the second quarter of next year – should continue to help cap any upside in yields.

Source: Wind, Bank of America Merrill Lynch, data as of June 2021

Note: The onshore bond data are based on domestic ratings, as compiled by Wind; the offshore bond data are based on international ratings, as compiled by Bank of America Merrill Lynch

 

Corporate bond yields declined marginally during the month, aided by ample liquidity conditions and moderate supply.

With the RBI taking delivery of its forward foreign exchange book, a reasonably steep curve and an attractive roll down, the belly of the yield curve continues to be relatively attractive. INR credit spreads are likely to stay within a tight range in the near future.

The Fed’s talk of tapering has pushed short-end yields higher with offsetting tightening in credit spreads. With a reasonably well anchored US policy stance, selective bonds in the short end of India’s corporates are suitable for carry, given better synthetic yields.

Source: RBI, Bloomberg, data as of June 2021. 

Headline CPI inflation rose above six per cent in May 2021, breaking through the upper limit of RBI’s inflation targeting band, owing to a generalized increase in prices including food and fuel (see page 1). Core inflation was also higher at 6.6 per cent. Elevated commodity prices contributed to an increase in the WPI.

As the second wave of Covid-19 dissipates in India and the economy reopens, the rupee has appreciated two per cent against the dollar. Furthermore, forex reserves continue to remain robust as the RBI continues its build up of reserves, while smoothing the volatility of the exchange rate.


For illustrative purposes only and does not constitute any investment recommendation in the above mentioned asset classes, indices or currencies. The views and opinions expressed herein are subject to change at any time.

Investment involves risks.  Past performance is not indicative of future performance. Any forecast, projection or target where provided is indicative only and is not guaranteed in any way. HSBC Asset Management accepts no liability for any failure to meet such forecasts, projections or targets. For illustrative purposes only and does not constitute any investment recommendation in the above mentioned sectors, asset classes, indices or currencies.

Equity

Source: Bloomberg, as of June 2021. For illustrative purpose only. 

 

The Indian equity indices have gained seven to nine per cent, on the back of better risk sentiment as the second wave of coronavirus infections dissipates.

Source: Bloomberg, as of June 2021. For illustrative purpose only. 

 

In terms of sector performances, real estate, utilities and materials were the best performers in May. On the back of rising commodity prices, materials is the top performer year to date, continuing its strong run relative to other sectors throughout this year.

Communication services remain a laggard so far this year, but another underperformer – consumer staples – are gaining traction after a slow start in the year, as the Covid situation eases.

Source: Bloomberg, HSBC Global Asset Management, as of June 2021. Total return in local currency terms.

 

For a second month in a row, Indian equities have recorded foreign investor outflows in May, albeit much less than the previous month. This is likely due to a risk averse sentiment toward the unfolding of the second wave of infections in April and May.

Investment involves risks. Past performance is not indicative of future performance. Any forecast, projection or target contained in this presentation is for information purposes only and is not guaranteed in any way.  HSBC Asset Management accepts no liability for any failure to meet such forecasts, projections or targets. For illustrative purpose only. The views expressed above were held at the time of preparation and are subject to change without notice. The information provided does not constitute any investment recommendation in the above mentioned asset classes, indices or currencies.

Sector overview – order of preferences

Source: Bloomberg, HSBC Global Asset Management, as of June 2021.

For illustrative purposes only and does not constitute any investment recommendation in the above mentioned asset classes, indices or currencies. The views and opinions expressed herein are subject to change at any time.

Any forecast, projection or target contained in this presentation is for information purposes only and is not guaranteed in any way. HSBC Global Asset Management accepts no liability for any failure to meet such forecasts, projections or targets.

Macro charts in focus

Source: Bloomberg, data as of June 2021

 

India’s second wave of Covid-19 continues to recede. Further loosening of virus restriction measures re-enables economic activity and mobility. Although the temporary disruption is likely to weigh on the upcoming quarterly GDP release for April to June, full year GDP growth for the current fiscal year is expected to remain robust due to low base effects and a strong economic rebound. That said, we remain vigilant on the economic scars from the first Covid-19, where the recovery has been uneven across the country, particularly across the labour market.

Source: Bloomberg, data as of June 2021

 

The economic recovery is uneven and potential downside risks stemming from the second Covid wave still persists. Therefore, the RBI maintains an accommodative stance and expanded its bond buying program. It also announced additional measures to support targeted sectors of the economy.

However, inflation risks continue to build. Core inflation in particular has experienced upward pressure from global reflationary dynamics. House inflation expectations also seem to show signs of hardening.

Source: Bloomberg, data as of June 2021

 

The last time the US Federal Reserve made policy steps to reduce asset purchases in 2013, a market tantrum triggered an outflow of capital from emerging market economies, including India. With weak external buffers, Indian equities and bonds were negatively impacted, and the Indian rupee depreciated by over 15 per cent.

This time around, in 2021, as the US Fed is taking steps to reduce monetary accommodation, the Indian rupee has depreciated by only about 1.5 per cent. That is due to stronger external buffers. In particular, foreign exchange reserves have grown to over $600 billion as of June 2021.

For illustrative purposes only and does not constitute any investment recommendation in the above mentioned asset classes, indices or currencies. The views and opinions expressed herein are subject to change at any time. 

Investment involves risks.  Past performance is not indicative of future performance. Any forecast, projection or target where provided is indicative only and is not guaranteed in any way. HSBC Asset Management accepts no liability for any failure to meet such forecasts, projections or targets. For illustrative purposes only and does not constitute any investment recommendation in the above mentioned sectors, asset classes, indices or currencies.

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