Will inflation rear its ugly head too soon to halt equity bull run?

Will inflation rear its ugly head too soon to halt equity bull run?

MUMBAI: A debate is raging among the global investment community as investors look past the Covid-19 pandemic and cheer the possibilities of a rapidly rebounding global economy: what will throw the spanner in the wheels of the equity Bull Run?

For many, the answer is runaway inflation, not only in India but in many of the advanced economies, particularly, the US.

The three major central banks — the US Federal Reserve, the European Central Bank and the Bank of Japan — pumped in close to $9 trillion in liquidity in 2020 to protect their economies from the damaging effects of Covid-19. They have also cut interest rates as low as they could, and promised to hold them there till the time it is necessary.

In addition to that, many advanced economies such as the US and the Euro Zone have also passed fiscal support measures worth trillions of dollars to help their citizens as they faced rapid job losses during the lockdown months of March and April. The US last month passed its second stimulus bill worth over $900 billion.

Students of traditional economics will tell you such excessive money printing by central banks and high fiscal deficit of governments are ought to fuel inflation, especially as the rapidly rebounding global economy helps bring back jobs and with them, demand.

While developed countries are yet to see inflation rear its head despite the rapid recovery seen across global trade, in India inflation is already troubling the Reserve Bank of India and limiting its space for further accommodative action.

“The MPC was of the view that inflation is likely to remain elevated… This constrains monetary policy at the current juncture from using the space available to act in support of growth,” Governor Shaktikanta Das said in his December monetary policy statement.

The concerns over inflation are such that RBI’s Monetary Policy Committee had to make a tacit plea to the government to act now to ease the bottlenecks in the supply chain created by local lockdowns and Covid-19 restrictions.

While the MPC expects inflation to moderate to 4.6-5.2 per cent in the first half of next fiscal year, its commentary suggests the forecast could change rapidly in the face of continued cost-push pressures such as surging global commodity prices.

Corporate India is already feeling the pinch, with consumer staples producer Marico warning investors on Monday that inflationary pressure in key raw materials had necessitated a cutback of some promotions and effective price increases.

Globally, prices of perishable commodities like wheat, corn, crude palm oil, beans and soybeans have hit their multi-year highs. Global crude oil prices have also soared 30 per cent in the past 90 days.

The global set-up

Marquee investors such as Louis-Vincent Gave of Hong Kong-based boutique research firm Gavekal Research warns that inflation in the US will come back with a vengeance, which will push up US Treasury bond yields, the benchmark for asset pricing across the world, beyond the 2 per cent level and plunge real yields for investors deeper into the negative territory.

Investors point to the rapid year-end rally in global industrial commodities such as aluminium, copper, iron ore, and steel to suggest that inflation will be knocking the door soon.

“I think we’re in gear. I think all the things that I see, following for years, as you have, tell me that this is an important shift that is going to last longer than people think,” Mike Wilson, chief investment officer and chief US equity strategist of Morgan Stanley, said in a recent interview to Real Vision.

Not everyone is convinced.

JP Morgan Chase & Co last month argued that the risk that prices won’t rise fast enough, or will actually fall, is more realistic than the threat that they will rise too fast.

The US-based investment bank believes the rapid adoption of technology, lack of possibility of large-scale fiscal spending in the US due to a divided US Congress and persistent ‘slack’ in the global economy will keep inflation expectations anchored.

Implication for equities

If inflation does come back with a vengeance in the developed world, it will put central banks such as the US Federal Reserve, whose money printing since March has largely fuelled the global equity rally, in a quandary.

While commentators believe the US Federal Reserve will be content with manageable inflation and see it as a sign of economic recovery, runaway inflation may force its hand to change course on its accommodative stance. If investors sniff a possible pivot in the US Fed’s policy stance, it could create turbulence in the global markets, reminiscent of 2013’s taper tantrum.

“We see scope for upside inflation risks from H2CY21 (July-December, 2021), which could create a disruptive shift in expectations on Fed policy,” brokerage firm Morgan Stanley warned in a recent note.

That said, moderate global inflation along with weakness in the US dollar will make asset classes such as commodities, emerging market equities and debt, gold, and cryptocurrencies attractive for global investors.

The accompanying global ‘reflation’ will lead to a chase for international assets causing inflows into emerging markets, including India, Morgan Stanley noted. Indian equities have already got some of those inflows since November, as overseas investors poured close to $13 billion in local stocks.

After a generation of low-inflation environment across the world, the shock created by the Covid-19 is most likely to bring inflation back into the investment calculus for investors.

What remains to be seen is how fast the old nemesis of economic growth and consumer aspirations will make its comeback.

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