Will Stocks Weaken Further under Rising Inflation and Interest Rates?
On Wednesday, the Reserve Bank of India (RBI) hiked the repo rate by 50 basis points (bps) or 0.5% to 4.9% in its effort to control inflation. Earlier, in a sudden shock move, on 4th May RBI had raised the repo rate by 40bps. Those who are now in their late-60s or older, would know that one of the chief features of the 1970s decade has come back. No, I am not talking of the return of disco dancing or bell-bottom trousers, but inflation. 
 
As high single-digit inflation persists in the West and double-digit inflation rages elsewhere, it suddenly seems as though nations have lost control over accelerating price rise which is the ultimate nightmare of economists, politicians and investors everywhere. 
 
Central banks are rushing to tighten money supply (reducing liquidity and raising interest rates) to control inflation and governments are, simultaneously, trying to tweak imports, exports and taxes, to control prices. 
 
They are facing two problems in doing so. One, after many years, the world is simultaneously under a demand and supply shock, with no immediate solution in sight for either. And, two, for the first time, inflationary expectations seem to be setting in which is what policy-makers dread the most. Inflation is as much a matter of perception as it is a matter of facts. If businessmen and householders believe that prices will rise (which economists call inflationary expectations), then their actions will further push up the price. 
 
In mid-March, I had asked in my column in these pages, “Is the stock market ignoring the coming inflation shock?” The market indices went up after that, dropped sharply and have risen to the same levels they were in mid-March. 
 
Key indices are vacillating, unable to find an answer to one crucial question: Can the central banks control inflation quickly by increasing interest rates and tightening liquidity? If yes, the market will go up. If not, the market will remain weak. One reason why we won’t get a clear answer to this question very soon is that monetary tightening is the only tool that can be deployed easily in the short term;but it is a blunt tool to control inflation. 
 
After all, to bring down prices, one has to increase supply, which seems impossible in the short term. So, policy-makers have to dampen demand to cut inflation. It is possible to cool demand, or so central banks believe, with tighter money supply. 
 
Unfortunately, monetary tightening cannot cut down demand for products that are non-discretionary like fuel, fertilisers, edible oil and foods, which are the main cause of inflation now. Tightening can only affect speculative investments, discretionary spending of the middle class and some asset purchases. 
 
This is why, among the first casualties of inflation, have been highly speculative 'investments' such as crypto-currencies and loss-making tech companies in need of a perpetual supply of cheap funds in order to survive. 
 
If monetary tightening mainly affects discretionary spending (of the middle class and the poor) and non-essential assets, how will demand for these essential items shrink? In the US, they recorded the highest increases last year: natural gas (176%), heating oil (100%), gasoline (91%) crude oil (70%), cotton (66%), nickel (55%), wheat (54%), coffee (48%). Prices of these commodities will cool when the supply increases which is not in the hands of central banks. 
 
However, if inflation does not drop, central banks will keep tightening liquidity, as long as that is the main tool available. This will destroy demand across the board, just like antibiotics which kill good as well as bad bacteria. 
 
The danger is that these decisions have to be made on the fly, and with hindsight knowledge; the tightening can go also go too far, especially if the economy is otherwise, strong as it is now. Indeed, in the US, the labour market is tight and dislocation in supply/demand in dozens of products, from energy, to food to industrial raw materials, is so severe that it may require extraordinary tightening to bring down inflation which will also shrink the economy. Such action could take even the US to the edge of a recession. 
 
As top US investor Bill Ackman says: “There is no economic precedent for 200 to 300 bps of Fed funds addressing 8% inflation with employment at 3.6%. Current Fed policy and guidance are setting us up for double-digit sustained inflation…It ends when the Fed puts a line in the sand on inflation and says it will do ‘whatever it takes.’ 
 
"And then demonstrates it is serious by immediately raising rates to neutral and committing to continue to raise rates until the inflation genie is back in the bottle.” 
 
All this is terrible news for stocks. 
 
As Ackman says, “If the Fed doesn’t do its job, the market will do the Fed’s job, and that is what is happening now.” If the US sneezes, emerging markets like India will catch a cold.
 
The Good News…
 
The good news is that the market does not react to past data; it is forward-looking. It will not wait for economic news to improve or for inflation to drop to 2% again. It will watch the intent of central banks, and if it is not satisfied, keep marking down the prices of stocks selectively (those with high valuations and low growth will fall sharply). Then, at some point, with the first downward tick of inflation, or when the valuation of quality stocks becomes attractive again, the market will rally. 
 
After all, valuations of leading Indian stocks are already back to the long-term average and companies are enjoying strong underlying demand. There is no sign of earnings recession as in the previous periods of high inflation. Also, the excesses of cheap money in India have been confined to the unlisted sector (which indirectly will affect consumption a bit) and a few outrageously-priced public issues. 
 
In short, the probability that inflation will come down on its own is low. This means, if  central banks act harshly now, the market will crash and then rally. If they are hesitant, the pain will be prolonged. 
Comments
pmbhate
2 weeks ago
“It suddenly seems as though nations have lost control over accelerating price rise”. “Central banks are rushing to tighten money supply to control inflation”. “After all, to bring down prices, one has to increase supply.”
The same nations and central banks bent over backwards 2 years ago and showered dollars and pounds to supposedly rescue their economies from collapse. US Government and US Federal Reserve alone ‘stimulated’ the US economy by giving away $5 trillion to its people and businesses. With so much money sloshing around in the system is it at all surprising that inflation ‘has raised its ugly head’ (a favourite phrase of the Indian press in the 70s)? The world has no option but to live with inflation. Indians are used to it, the rest of the world is learning. Just as it learned during the OPEC triggered oil shock in the 70s.
Jagadesh
3 weeks ago
Simple and effective explanation !
saharaaj
3 weeks ago
Thanks to single minded pursuit of Profift by MNC manufacturing shifted to so called third world . Smart merit driven made the geographies as second world. . Now the situation is if China/Xi ping sneezes Wall street catches cold . If XI catches cold Wall street catches pneumonia. So watch Xi health and see the trajectory
shrine221
3 weeks ago
When Central Bank is managing casino which is share market with the help of government how the market will crash
FII selling billions of stocks and still market not ready to react it means something is very serious
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