The latest wholesale price index (WPI) data is mildly surprising. On a year-on-year (YoY) basis, the July 2012 WPI was 6.9 per cent higher than that in July 2011. This was lower than the YoY change of 7.3 per cent in June 2012 and in fact, lower than it’s been since November 2009. But the YoY change in core inflation (inflation of non-food, non-energy items) hit 5.4 percent in July 2012, up from 4.9 per cent (the lowest level since November 2009) in June 2012.
Crude prices have risen in August 2012, and a poor monsoon makes high food inflation likely. So, non-core inflation could spike in the next two WPI releases. However, the weak Index of Industrial Production suggests core inflation may drop again.
The optimists would say that the RBI’s hawkish stance since February 2009 has tamed inflation at the cost of growth. But the central bank seems to have decided that it will not cut interest rates, unless there is a broad fall in inflation data across both core and food-fuel items.
Since that’s unlikely, the RBI will probably hold the line in its mid-September credit policy. It would not be surprising if it made only token cuts, or none until December 2012. In effect, it seems the central bank has gotten tired of being the only proactive policy agency. The RBI governor has said several times, and with justice, that he believes monetary policy has done all it can and it’s up to the government to tackle the supply side issues that are keeping inflation high.
The policy paralysis over the past six quarters has pushed the economy to the verge of genuine crisis. The external balance of payments (BoP) is poor. The fiscal deficit is large and climbing. Bank finances are stretched due to rising non-performing assets and higher levels of debt restructuring.
This is Catch-22 for policy makers. Any constructive policy action the government takes to boost investment will lead to a fight between UPA allies. Attempts to cut expenditure will face opposition from the Congress’ high command. If a ‘do nothing’ policy continues, there is a real chance of the fisc going out of control or an external BoP crisis. Either situation could force drastic action in an election year.
None of this is secret. The impact on India Inc is obvious. Corporate profit margins have fallen for five quarters, dropping below 5 per cent in April-June 2012. Interests costs have ballooned. Under the circumstances, the fact that equity prices have held steady is surprising. Either ‘Mr Market’ knows something that we don’t, or share prices are completely out of line with fundamental projections.
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Take a quick look at valuations. In the last four quarters, earnings have grown at single digits. The slowdown has been broad-based with almost every sector hit. During the same period, treasuries have offered yields in excess of 8 per cent. A price-earnings-to-growth (PEG) valuation-model suggests the Indian stock market should be valued at a PE of less than 10. If you use an interest yield to earnings yield comparative model instead, valuations should be PE 12-13.
However, the CNX500 and the BSE 500 (these indices are almost identical in behaviour) are both trading at over PE 17, the Nifty and Sensex have similar valuations. This implies that a fall of at least 20-25 per cent would be required to bring the market down to fair value. Since markets overshoot when trends develop, a deeper correction seems possible. A bear would be tempted to wait for such a projected correction to occur.
As a thought experiment, assume that the market discount of PE 17-18 is somehow correct in its apparently optimistic valuation. Earning growth rates would have to more than double within fiscal 2012-13 to justify PE 17-18 on a PEG model. Or, if earnings growth remains at current levels, interest rates would have to fall to around 6-7 per cent to justify PE 17-18 on a comparison of interest yields to earnings yields.
In practice, earnings growth cannot climb so much without serious interest rate cuts. But let’s consider the possibilities separately. The RBI will not cut policy rates by a cumulative 150 basis points in the next two credit policy reviews. Consensus earnings estimates suggest the pattern of low earnings growth and slowing sales will continue as well for at least another two quarters.
So why is the market stable? The immediate cause is FII inflows despite all the negative signals. If the FII stance changes, the market will see a deep correction. Watch the FIIs with due care. Another round of bad news from Europe or the Middle East or the US could trigger a huge sell-off in India.