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Why investors should keep an eye on rising inflation in advanced economies

Why investors should keep an eye on rising inflation in advanced economies
May 18
13:30 2021
Central bankers managed the needs of the economy with their kid gloves on.

Central bankers managed the needs of the economy with their kid gloves on.

The fear of rising inflation spooked markets across the globe last week.

When easy money was finding its way into the asset markets and driving up prices across both bonds and equities, no investor worried about inflation. Central bankers managed the needs of the economy with their kid gloves on. Investors were delighted as they benefited from high doses of easy liquidity injected time and again by the central bankers over the last several quarters. This easy liquidity pushed up the prices of almost all assets in stages.

However, uniform behaviour wasn’t seen across the globe. For example, real estate prices in India did not see much investor interest despite easy liquidity. Central bankers worried about growth and pushed inflation worries backstage. The massive health scare amplified by the scarcity of healthcare systems in some parts of the globe, delayed availability of vaccines, and rising job losses forced several central bankers to embark on a larger-than-anticipated easy monetary policy from last year.

RBI governor Shaktikanta Das jumped into action from early 2020 and extended a helping hand to bankers, market participants, and the entire credit market. After a few large credit busts over 2018 and 2019, credit defaults were avoided due to multiple measures including the extended credit moratorium (wherein the banks were not required to recognize delays in debt repayments) offered by RBI.

Against this backdrop, the big question is, will central bankers pull back on easing measures due to the jump in global commodity prices and the rise in consumer price inflation in the US?

Both the equity and bond markets get impacted due to a rise in inflation. Last week, Indian and global equities saw a sharp correction, and the 10-year US treasury yield has moved up. Rising bond yields make the cost of money expensive, making bonds attractive relative to equities.

Will this impact Indian markets?

The Indian market is impacted by the behavior of both domestic and foreign investors. Investor behaviour so far is on expected lines. Moreover, the impact on the debt market is expected to be limited relative to the impact on the Indian equity market. Ownership of Indian debt by foreign players is under 7 per cent, hence their investment behaviour will also have a relatively lower impact.

The assets of foreign investors in the Indian equity market are significant and any reallocation by them generally impacts equity prices. Moreover, any trade in either the equity or debt market by the foreign investor, in turn, influences the Indian rupee. Any pull out of dollars will weaken the rupee, and any investments by foreign investors (wherein they bring dollars) will strengthen the local currency.

The trend in asset prices depends on the macroeconomic position wherein inflation plays a pivotal role. Interestingly, CPI in India may remain dovish while global inflation heads northwards. The macro parameters in India may move differently from the global macro parameters as India grapples with a weak health care system, slowing economic activity, the onslaught of the second COVID wave, and delayed availability of vaccines. The direction of domestic inflation is influenced by both aggregate demand and supply. Overall, the prices are expected to remain low due to lack of demand; however, supply chain disruptions due to lockdown in certain states pushes up the prices in certain items.

The after effects of the rise in global inflation will be felt only if foreign investors feel the need to reallocate their investments. Suppose US rates move higher due to US CPI going higher, the interest rate differential between India and the US will narrow. From a risk-return perspective, investments into US bonds will become favorable relative to investments into Indian bonds. But any selling by foreign investors of Indian bonds will be absorbed by domestic investors.

However, there could be repercussions in the Indian equity market, since foreign investor holdings are significant. That could happen in case the global investors feel the need to reallocate from EMs favoring DMs, due to narrowing interest rate differential, falling price-earnings multiple in international markets, and a firm US dollar.

However, based on the comments from the Fed so far, it appears that they will continue with the stimulus for the time being irrespective of the jump in the inflation data. Global investors are trying to anticipate a possible rise in interest rates due to the recent inflation data.

The market will continue to track the central banks’ policy measures. The level of interest rates will determine whether any investments need to shift between equity, bonds and cash, or between emerging markets and developed markets.

The rise in commodity prices suggests that there could be some policy change sooner than later—all eyes are therefore on macro data and policymakers.

(Sujoy Das has over 25 years’ experience as a fixed income money manager at Invesco Mutual Fund, Bharti Axa MF, and DSP Merrill Lynch MF. Views are personal)

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