Keep buying on dips

Stock market will eventually recover, giving healthy returns

Stagflation is a combination of high inflation and GDP growth stagnation. It is one of the most difficult situations to combat. Various governments have adopted different strategies. There is no single formulaic solution. A lot depends on what policy-makers think politically acceptable.

One method is to cut inflation by squeezing money supply and making money more expensive by raising interest rates. Another method is to somehow improve productivity and efficiency and thereby make goods and services more abundantly available and cheaper. A radically different method is to pump prime by increasing money supply and making huge investments to stimulate demand.

All these have dangers attached and they can all cause massive grief to the average citizen. The monetarist tightening of money supply can lead to demand being choked off. Pump priming causes rising deficits. It can send government finances out of control and leave crushing debt burdens that destroy faith in the currency. It can also lead to horrendous spikes in inflation.

Improving efficiency and productivity sounds the ideal way in theory. But in practice, it often means re-examining entire value chains and undertaking to implement painful reforms. Quite often, this means jobless recoveries where unemployment rises.

As of now, India is not in stagflation but all the signals suggest that it is suffering a demand recession and certainly, it has an inflation problem. It’s impossible to set timeframes for improvement. The key bottlenecks are high fuel prices and expensive commodities in general, and both of those situations reflect global dynamics. It’s anybody’s guess as to how long it will take before things improve. Nothing the Indian government does on its own will really impact either of these situations.

Every credible estimate for 2011-12 has already pared down GDP growth projections. If you assume that inflation is actually under-stated and it is, real GDP growth is likely to end up being 100-150 basis points lower than the already-reduced estimates. That means India could be looking at a scenario where inflation is double-digits and real GDP growth falls to around 6.5-7 per cent through the current fiscal.

What is worse is that India is likely to be among the better-performing major economies through this period. The US is staggering along at less than 2 per cent GDP growth in the past two quarters, Japan could deliver negative numbers and the Eurozone is faced with a huge currency crisis. Hence, it’s difficult to imagine that the external sector will help pull India out of the hole.

By most standards, GDP growth rate of 7 per cent would be considered excellent. Unfortunately, it is just about enough to keep the

Indian economy ticking over. We’ve got used to expectations of 8 per cent and more in the way of GDP growth. Given all the wastage in public finances - huge subsidies and huge government deficits- anything less than 8 per cent is a belt-tightening situation.

Anecdotally, the average middle class consumer doesn’t have expectations of real discretionary surpluses, or expectations of income hikes, at anywhere below 8 per cent GDP growth, especially if CPI is running at near 10 percent or more. Since over half of GDP in the current fiscal will be produced by consumer action, this guarantees a demand slowdown.

Analysts tracking corporate earnings have pared expectations down considerably and Foreign Institutional Investors (FIIs) have cut their India allocations as well. However stock market valuations are still stubbornly high. India is the most expensive of emerging market in terms of any of the standard metrics such as average PE, PBV and so on. It is also likely to get hit by further interest rate hikes and further earnings downgrades in the next couple of quarters.

There's room for progressive equity de-rating under these circumstances. Stock markets discount future expectations. Those expectations will get progressively worse before they start getting better. How much worse they will get is again a difficult call to make.

Historically, the past few Indian bear markets have reflected the global situation. They have resulted in pullbacks of 50 per cent or more from the previous peaks. It would be prudent to assume that this could happen again with the Nifty eventually landing in the zone of 3000-3500, given previous peaks (January 2008 and November 2010) in the range of 6350.

The investor shouldn't exit equity. There is no safer haven in the circumstances because debt instruments may suffer even more. But the investor should be prepared to average down and increase equity commitments at lower levels. The stock market will eventually recover. When it does, a widely diversified portfolio will see strong capital gains.