High inflation and interest rates: Impact on investors, markets

The spike in retail inflation in July to 7.44% has created some uncertainty in the minds of investors and savers. Analysts do not expect a cut in interest rates in the current fiscal; there is in fact, talk of a possible rate hike going forward.

The shape of the earnings growth trajectory this year is more critical than in an average year — the so-called Goldilocks scenario for India, the ideal state in which all factors in an economic system are just right, depends on it.

The GDP is expected to grow by 6.5% in 2023-24, and the benchmark Sensex is currently at the 65,000 level. But if inflation remains high, returns on stock market movements may be impacted. However, gold and bank deposit rates are expected to remain steady in the coming months.

Inflation outlook

The Reserve Bank of India has projected inflation to stay above 5% until the first quarter of 2024-25, and is likely to hit the 6.2% level in the ongoing quarter (July-Sept). This is above the RBI’s comfort level of 4%.

Food price pressures are expected to stay for another couple of months. The July data highlight not just the surge in vegetable prices (37.3%), but also inflation in cereals and pulses (13% each), spices (21.6%), and milk (8.3%).

“For now, the pressure from food prices remains the big worry and can cause the headline inflation to run red hot for another 2-3 months, after which government intervention (releasing food stocks, facilitating imports and restrictions on hoarding) and fresh crop arrivals should provide some relief,” rating firm Crisil said in a report earlier this month.

Debopam Chaudhuri, chief economist at Piramal Enterprises, said the kharif crop will be key: “We need to be prepared for a systemic rise in volatility in food inflation owing to increasingly erratic climate patterns. Monetary policy needs to adjust to such shocks.”

Interest rates

Rajani Sinha, chief economist at CareEdge, said the steep upward revision in inflation projections have pushed the expectation of a rate cut to the next fiscal (2024-25).

Crisil said: “While we expect the Monetary Policy Committee of the RBI to hold policy rates in its October meeting, the evolving inflation dynamics suggest that policy is likely to remain tight for longer with the first rate cut seen only in the early part of next fiscal.”

Chaudhuri said it was unlikely the inflation data would “re-trigger a rate hike programme in India, as globally retail inflation is on the decline”.

The RBI, while retaining the repo rate at 6.50%, revised its FY2024 inflation projection to 5.4% from the 5.1% announced in June. Retail inflation is expected to be at 6.2% in the second quarter, 5.7% and 5.2% in the third and fourth quarters respectively of FY2023-24.

“This means the high policy rates will remain high for long and, therefore, a rate cut can be expected only in the first quarter of FY25,” V K Vijayakumar, Chief Investment Strategist at Geojit Financial Services, said.

Impact on markets

In theory, stock prices are undervalued and gold gains ground when inflation is high. When inflation rises, it means the cost of living is also going up — which in turn, means lower purchasing power for people. In short, when inflation goes up, people earn less in real terms, net of inflation.

Also, higher inflation means higher interest rates, and that also impacts the cost of equity. The RBI had raised the policy repo rate by 250 basis points to 6.50% since April 2022, leading to an overall rise in lending rates, including home and personal loans.

A report by Motilal Oswal pointed out that when the inflation rate rises, interest rates and bond yields will go up in tandem. India’s benchmark 10-year bond yields have risen by 10 basis points to 7.20% over the last month.

“When inflation goes up, and the interest rates also go up, the cost of capital will also go up. The cost of capital is a combination of the cost of equity and the cost of debt. When the bond yields go up, the cost of capital goes up, and therefore the future cash flows of the company will be valued lower. …The valuation of equities is done by discounting future cash flows. When the rate of discounting goes up, obviously, equity valuations go down,” the report said.

Markets outlook

Despite rising inflation and high interest rates, India has been the best performing market since March 2023. The FTSE India index is up 16.7% in US dollar terms — FTSE Asia excluding Japan was down 5.2% — led by FII flows, supported by a strong earnings outlook and relatively stable macro conditions.

“After this rally, valuation has risen, inflation has shown…[an] uptick, and crude has inched up. Amid escalating concerns on global growth, India still stands out, but earnings resilience is key to sustain positive momentum,” HSBC said in a report. “Hence”, the report said, “the shape of the earnings growth trajectory this year is more critical than an average year and India’s ‘Goldilocks’ scenario rests on it.”

STOCKS: Investors with a long-term investment horizon should stay invested in their holdings provided the earnings of these companies are good and there are chances for appreciation. They can pick up more fundamentally strong stocks that are attractively priced.