Since the heady November Sensex heights the Indian market has been one of the world’s worst performers. Prime among investor concerns has been inflation. But the negativity around inflation has reached a point where it is losing sight of the facts. Inflation is high, but it is now declining, and the direction of inflation is more important to Indian equity returns than its level. Our analysis highlights the impact of different inflationary conditions on different sectors in India.
Inflation is high, but moderating
With an average WPI rate of 9.4% from April-December 2010 vs. a decadal average of 5.3%, inflation has clearly been a serious issue. The renewed spike in December spooked investors, with perceived upside risks from food and oil prices (24% & 15% weighting in WPI respectively). Whilst oil risk is unpredictable, food price inflation in India is predominantly determined by domestic factors, mainly the monsoon, and a normal monsoon, high base effect and policy action are bringing it down, falling below 10% this week (vs. 17% in late Jan).
Core inflation is also moderating due to softening demand conditions and tight liquidity. Supply side factors mean that India will have to live with a higher “normal” rate of inflation over the medium term, but the combination of the factors cited above and a likely further 50 bps of RBI tightening in H1 suggest the near-term direction is towards the 6-7% range for FY12.
Indian markets moderately correlated to inflation
We’re not claiming inflation doesn’t matter to returns. It does. But the relationship is not nearly as clear cut as is often made out, both globally and in India. There is a negative correlation in India between the level of inflation and real equity returns, but not a strong one (-0.33). Somewhat counter intuitively, we found that there was no significant impact of inflation on Sensex companies PAT margins. This lower than expected correlation and impact on margins appears due to a combination of the higher growth in corporate revenues, pricing power of strong brands in regulated markets and ability to exploit uncertainty caused by rapid price changes, and lower distortion in the capital gains tax regime in India. High inflation (above 6%) does negatively impact Sensex & BSE 200 returns, but not as much as is assumed.
There are three important points to note about India that may help explain a lower correlation between overall inflation and real equity returns:
1. Many sectors/industries remain highly regulated and more protected from competition, and conglomerates with strong brands still loom large, and have better pricing power and ability to exploit inflationary conditions to push through price rises.
2. The worst performing sectors in the developed world in a high inflationary and policy correction phase are Retail, Building Materials and Leisure & Hotels, due to the impact of higher borrowing costs on consumers. Whilst the impact of borrowing costs impacts Indian property, consumers do not in general borrow to buy consumer goods in India, the way they do in the West.
3. The distortion in the capital gains tax system is much lower in India than most other countries. Whilst short term capital gains <1 year are taxed at the marginal tax rate of 33%, for long-term capital gains >1 year, the rate falls to 10% not using the indexation method or 20% if using the indexation method to account for inflation, so the capital gains tax is effectively 10% or less. This
is lower than most other capital gains tax regimes.
Direction of inflation more important than the level
Our summer 2010 strategy research took a bearish view on inflation risk as we moved sharply from a low to high inflationary environment. But the situation is now different. We are still in a high (8.23%) inflationary environment, but this is likely to moderate. Yet the direction of inflation is getting much less attention than its level.
Our analysis shows how Indian press articles on inflation have peaked recently, well after WPI started to decline, influenced by global commentary as other countries face inflationary pressure. But India is at a different point in its inflationary cycle to other countries. The correlation between real Indian equity returns and direction of inflation is better than simply the level of inflation (-0.41. vs. -0.33), and the annual nominal Sensex return was 39% in months of decreasing inflation.
Sector impacts in different inflationary conditions
We have analysed the impact of different inflationary conditions (both high as well as declining) on costs, margins and performance across sectors. Three main margin pressures stem from inflation; a) input costs b) compensation costs and c) financing cost. Oil, Autos & Consumer Durables are most susceptible to the impact of high inflation on costs. Healthcare is the most defensive sector. Just as direction of inflation better explained overall market performance than its level, so the same applied to sectors. So which sectors are best placed if ones takes the view that inflation will moderate? Historically Metals, Autos, Power and Consumer Durables sectors performed best in an environment declining from high to moderate inflation.
Inflation = Bad?
Inflation has become the dominant concern for Indian policy makers. It is the biggest worry for many investors into India. It is also an important case study for global investors given India has the highest inflation of any major economy.
There are two key questions; 1) how persistently high is inflation likely to be and 2) what are the implications for investors of both its level and direction? An analysis for equities and inflation data for 16 countries representing 90% of global equity market capitalisation and 87% of OECD GDP shows that the relationship between inflation and real equity returns (inflation adjusted) in the past 100 years was not clear cut – there is a negative correlation, but not a strong one. This negative correlation also does not apply for all countries.
The negative correlation is also vulnerable to extreme observations; remove years of very high inflation rates and the correlation drops sharply – strip out inflation rates above 20% and the correlation coefficient falls to -0.33, remove inflation rates above 10% and it falls to -0.17 and
remove 5% rates and it falls to -0.09. India itself has a correlation of -0,33, so lower
than the world average.
Our point is not that inflation doesn’t matter to returns. It does, and clearly investment strategy has to be adapted to current and prospective inflationary conditions. But the relationship is more nuanced than most of the commentary suggests. There is a wide dispersion of experience between countries, between different sectors, between different levels of inflation (levels >7% begin to have a more significant effect), and point in the inflationary cycle (is it the level of inflation that matters, or its direction?).
Moderate inflation & high GDP growth best for Indian markets
Our analysis of Sensex returns shows that though high inflation (more than 6%) does negatively impact returns. The Sensex does best in a moderate inflationary environment (WPI between 3-6%). In the analysis, we divided each quarter between Q4FY00 to Q3FY11 into ‘low’, ‘moderate’ and ‘high’ inflationary quarter based on the average inflation in that quarter, then compared the quarterly returns on the Sensex and BSE200 indices in these three categories of quarters. Additionally, quarters are assigned as a ‘high’ GDP growth quarter if GDP grew by more than 7% in that quarter and ‘low’ GDP growth quarter otherwise.
Moderate inflationary environment coupled with high GDP growth is optimal – the Sensex delivered a quarterly return of 12% in the high GDP growth and moderate inflationary environment.
Given that inflation is likely to remain in high territory (more than 6%) for most of 2011 but is expected to moderate from current levels of 8.23% towards 6% by the end of 2011, we’ve tried to highlight the investment implications forboth high inflationary environments, but also for a declining inflationary environment.
In regards to cost inflation, Banks, Healthcare and IT sectors are relatively insulated from high inflation, while Oil & Gas, Auto and Consumer durables are highly susceptible.
In regards to sector performance, Power, Metals, Capital Goods and Auto have underperformed in high inflationary environments while IT, Banks, FMCG and Healthcare sectors’ performance remained relatively at par with their long term averages. Moreover, as highlighted above, directional inflation is a better indicator of returns. We note that Metals, Auto, Power and Consumer Durables sectors are best placed in a declining inflationary regime.