Stagflation — a term coined by bridge international (and British politician) Iain Macleod — describes one of the worst economic situations when growth stagnation is combined with price inflation. India has been heading this way for the past year. The credit policy and the budget did nothing to reverse this trend.
Growth has slowed over the past three quarters, while prices have risen. Such a scenario is difficult to handle because it requires a delicate policy balance to stimulate growth without sending inflation out of control.
Indian inflation is mostly due to supply-side issues. Demand has grown a little but the supply of key commodities has become more expensive, due to logistics issues. A major part of the problem is oil-shock. The budget will overshoot deficit estimates and inflation will probably remain high since the Budgetary Estimates assume an average crude price of USD 115 per barrel in 2012-13 where USD 125-plus is much more likely.
In addition to high crude and gas prices, there have been persistent coal shortages (as well as a massive coal scam) and food prices have gone through the roof. These are domestic issues and large scale reforms are required to increase efficiencies.
Inflation can be tackled in two ways and these methods are very different from one another. One method is to increase the supply of goods and services. The other method is to make money more expensive and scarce by raising interest rates and thus, reduce demand.
The first method works better for supply-side issues. But growth needs to be fuelled by cheaper money that entrepreneurs can borrow to invest. When money supply is eased, it immediately stokes more inflation and causes prices to rise before it translates into growth and eventually falling prices.
So easing money supply guarantees some votes that are lost due to inflation. Hence, betting on growth in an inflationary situation is a politically risky strategy. In India, this is more difficult because reforms are required, in addition to easy liquidity. If the will is lacking to implement reforms, growth won’t pick up enough even if liquidity is eased.
The “politically safe” alternative strategy is to cut money supply and hike interest rates. This may lead to prices falling though it is much less effective with supply side problems. Expensive money impacts growth for sure. The short-term damage from slower growth is “politically invisible” whereas inflation has a visible impact.
In a stagflation situation when inflation is due to supply-side problems, the “safe” strategy is wrong. It cannot pull the economy out. Eventually, voters get tired of a situation where their nominal incomes continue to fall while prices rise. If interest rates are hiked during a stagflationary period, you are committed to waiting it out indefinitely.
Drastic action, by easing money supply and carrying out reforms is the only way to counter stagflationary trends. The RBI should have started easing interest rates at least six months ago and the Finance Minister should have taken determined reform measures. Since neither happened, the government has decided to trust the fate and hope the situation corrects naturally before the General Elections in 2014. As Lok Sabha election deadline approaches, political considerations make it difficult and even impossible to even think of reforms. So this budget was the last real opportunity for proactive decisions.
What should an investor do in such a situation? Well, the best he or she can do is to make a comparative analysis of alternative investments and try and pick the best mix. Unfortunately, stagflation is the kind of situation when no instrument performs well so it is a situation when the investor must choose the path of least damage.
Real estate prices have already fallen and will fall even more. At the same time, mortgages are becoming more difficult to obtain, and more expensive to service. Many real estate developers are very cash-strapped and some projects are likely to be stalled. There’s a real risk that, if you buy new real estate now, you could see long delays in taking possession as well as discover that the price of your asset has fallen.
The nightmare situation would be to see your money stuck in a half-built property, with real estate prices falling, and an expensive loan to service on a higher cost of acquisition. I’d steer clear of real estate for the moment.
The institutional expectations in debt seem inclined to bearishness. This is partly because of the RBI’s hawkish stance and partly because heavy government borrowing is driving corporates out of the market. Treasury Bills of 3-months to a year’s duration are trading at yields of 9 per cent plus, while 10-year government bonds are available at 8.4 per cent. The apparent absurdity of yield inversion occurs when the market expects short-term government borrowing to continue in large volumes. Yield inversion could mean that short-term rates harden a little more.
However, debt is paradoxically becoming a little more attractive. The RBI hasn’t cut policy interest rates yet. But it has halted the rate hike cycle, at least temporarily. If you park money in mid-term fixed deposits now, you will receive the benefit of a high rate of return. If you invest in debt funds, you could receive windfall gains as and when interest rates drop. A rally in the debt market is likely to occur before there is a rally in equities.
Equity as always, remains a puzzle. Earnings growth is slow, interest rates are high. Valuations are way above “fair-value”. The current Nifty PE of 19 can be justified either by an interest rate of less than 6 per cent or by the prospects of 20 per cent earnings growth. Neither is the case at the moment. Domestic institutions have been consistent sellers and so have domestic operators. However, FIIs have been huge net buyers in the past three months.
I don’t think this situation is sustainable and the market is likely to see a deep correction before it rallies. This could occur if FIIs lose their appetite or if the fundamentals get even worse. But even if there’s a crash there could also be a major rally before the 2012-13 fiscal ends. So you cannot abandon equity.
My advice would be to maintain systematic investment plans (SIPs). At the same time, create a war chest of cash held in short- and medium-term debt. If the market falls by 10 per cent, increase SIP allocations by 10 per cent. If the market falls 20 per cent, increase SIP allocations by 20 per cent. You could vary the quanta but the basic strategy is to increase equity exposure at lower prices.
Two relatively short term trades may be interesting if you can stomach higher risks. One is to book profits in gold (assuming you have investment holdings rather than jewellery) and transfer some of those holdings to silver. Precious metals could continue to appreciate in the current investment climate but silver is likely to outrun gold.
The second short-term play may be to buy the dollar and sell the rupee by going long on the USDINR contract. There will be pressure on the rupee and that could translate into big gains, given the leverage of nearly 50:1 on the futures contract. However, this trade is high-risk precisely because of the leverage. Set stop losses and be prepared for rollovers if you dabble in forex derivatives.
Net-net, avoid real estate. Increase exposure to debt funds. Hold current equity exposures and be prepared to switch debt allocations into equity and increase equity exposures if there’s a large correction. Don’t expect much in the way of returns in the 2012-13 fiscal.
This article was originally published on April 21, 2012.
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