The uptick in commodity prices has brought back the prospects of inflation. However, the price increase in many cases is on account of supply disruptions/ reductions rather than any significant demand uptick, as the world continues to fight Covid-19.
Prospects of a rise in inflationary pressures have resulted in a sharp uptick in bond yields. Going forward, global growth rates are expected to accelerate as vaccination progresses in a bid to tame Covid-19. The supply of commodities has to keep pace, if price rise is to be contained. Else, we could see higher inflation in CY21, at least for some time with consequent higher bond yields and tighter monetary policy.
The increase in bond yields has punctured the equity rally, as borrowing costs rise and currencies became volatile.
We witnessed a similar phenomenon for a large part of 2008 to 2014 in most commodities, when the world was coming out of the Lehman crisis and seeing strong liquidity infusion into the system. Some of this liquidity was coming into financial assets as well as physical assets.
While the underlying cause may have been different, the weapon to fight the issue was the same, i.e. liquidity injection. It would be interesting to see how the markets behaved in the period.
Between September 2008 to November 2014, while inflation did move up, except for the period when repo rates rose 3.5 per cent in a period of two years (Oct 2009 to Dec 2011) and index returns were negative, the index did deliver strong returns in other periods.
The Oct 2009-Dec 2011 period also saw slower-than-usual economic growth, which in itself could have been caused partly by higher interest rates, that impacted profit growth and, hence, market performance.
During this period of interest rate rise, asset-light sectors such as autos, consumers, IT and pharma did well. Free cash flow generators did well. However, these spaces did well in other periods too, and their market performance was more on account of their earnings growth prospects.
When these sectors did not grow well, their stocks also took a step back in the market. Higher interest rates are less of an issue for sectors like IT, pharma and FMCG. However for autos, it does increase the overall cost of ownership. The key takeaway here is, following earnings is more rewarding in investment than following interest rates.
In other periods, when interest rates moved up gradually, the market has been able to deliver positive returns. As policy bites and commodity prices run their course, inflation-causing sectors typically underperform, while for a period of time, they must have experienced supernormal profits.
Markets clearly understand that high commodity prices could mean-revert.
To sum up,
- Indian interest rates have been falling. They did take a step back, but the overall direction is that of a decline.
- Sectors that have a promising outlook do tend to deliver strong returns over the period when interest rates may move up. While some sectors have been more consistent, it is also because their earnings growth have been more consistent.
- Consistent performers fall out of favour when the earnings trajectory gets impacted. This was seen in seen pharma and auto.
The idea, hence, should be to focus on the businesses that one is holding: valuations and growth prospects that is being presented. Indian economic growth CAGR is of an order higher than most parts of the world and, hence, high-quality growth becomes the primary driver of returns vs any other factor.
The market has corrected in March as bond yields have risen globally. Basis the above, we do expect the March correction to be a temporary setback. Buying the dips should be a great investment strategy in this period as India Inc is expected to deliver strong YoY earnings performance in Q4 FY21 and Q1FY22. The economic growth would be strong in FY22 and there could be upward surprises in earnings.
Moreover, while bond yields may have risen, it would take time for the policy rates to rise, as central bankers have already commented upon. Dips should be bought into in the high-quality space.