Once growth recovers, inflation will become the focus. With domestic inflation risk on the upside, along with the overhang of global interest rates going up, domestic interest rates are likely to increase.
India’s average consumer price inflation (CPI) has averaged 5.2 per cent year-to-date in FY22, while the same for producer or wholesale price inflation (WPI) averages at 11.7 per cent. Historically, since 2014, WPI has been below or around CPI. However, since April 2021, there has been a divergence and that too a very pronounced one.
What Has Led To The Divergence?
Composition of the two indices: There is a structural difference in the composition of the two indices. While CPI is oriented towards food (and services), WPI has higher weightage for manufacturing. This contributes to the divergence. For instance, food and beverages account for 46 per cent of the CPI basket but only 24 per cent of the WPI basket. Manufacturing accounts for 53 per cent of the WPI basket while services, including housing, forms 36 per cent of the CPI basket.
Effect of inflation, prices: Global supply shocks and commodity price spikes are reflected in the components under the manufacture basket of WPI such as textiles, chemicals, paper, rubber and metals, which are exhibiting high to very high inflation. In comparison, absence of manufactured components is having a lesser degree of impact on CPI. That said, some items within the CPI basket, such as clothing, footwear, transport, recreation, household goods and health, are showing high single digit or low double-digit inflation suggesting that CPI is not completely immune.
What Does This Mean For Producers And Consumers?
Producers are facing margin pressure with high cost of inputs and are unable to fully pass on the costs to the consumers in the wake of a weak demand scenario. The growth is still fragile, and producers are therefore confronted with the enigma of demand versus price hikes.
Consumers have also been witnessing a mixed bag. While overall food inflation is low, oils and fat has seen a consistent 30 per cent-plus inflation. Prices of protein led items have been high and vegetable prices are increasing month on month. Fuel prices are already pinching the purse.
How Will The Divergence Converge?
We witnessed a reverse situation in the past when WPI was significantly below CPI. This was during 2015 and 2016 when oil and global commodity prices saw a sharp decline, and once again in 2020, during the onset of the pandemic when global demand saw a steep fall. This divergence led to a convergence with WPI trending close to CPI as commodity prices recovered.
In the current circumstance, economic recovery will drive demand recovery. Producers will continue to pass on the price increase to consumers. Consumer price inflation will eventually see a second order impact. Structurally, core CPI (CPI excluding food and fuel) has been moving upwards and is sticky. Reversal in food inflation bears an upside risk to CPI. On the WPI side, as global supply chain improves commodity prices may cool down eventually softening WPI.
It is likely that the divergence will occur on both parameters; CPI will inch higher while WPI will also come down. Six months down the line, base effects itself may soften WPI (year-on-year will come down statistically) even if underlying prices remain elevated.
What This Means For Interest Rates?
Globally, inflation is a point of contention for central banks pressuring them to take rate hiking actions. The domestic circumstances may not be any different. The Reserve Bank of India (RBI) is showing patience to support growth. Once growth recovers, inflation will become the focus. With domestic inflation risk on the upside, along with the overhang of global interest rates going up, domestic interest rates are likely to increase.
What this means for savers is that the real returns, i.e., inflation adjusted returns, in the low-risk segment (term deposits, AAA-bonds) will not improve significantly in the short to medium term.
A rising interest rate cycle is a deterrent for bond investors to invest in longer maturity bonds as the capital losses are higher in the holding period versus shorter duration bonds. Longer duration bonds are now fraught with duration risks. Equity markets have perhaps delivered their due ahead of time.
Where Can Investors Find The Juice?
There is one segment of the market that has not benefitted much from the post-pandemic rally. This is the credit segment. The RBI has provided large accommodation in the form of banking liquidity and rate cuts to support the credit environment during the pandemic. However, the benefit of low rates has largely gone to the AAA segment and government borrowing only.
A large portion non-AAA segment has not benefitted, primarily due to risk aversion. While the benefit of a 250-basis point rate cut from 2018 has translated into similar gains in the AAA segment, the non-AAA segment (particularly AA and below) has not enjoyed similar gains. Large corporate defaults aggravated by the pandemic related risks has perhaps led to a very long overhang on the risk segment. This is reflected in the low credit growth of the banking system. Also, appetite from institutional investors and banks for such issuances itself have been low in the recent past.
Investors can, therefore, find reasonable high single-digit yields from non-AAA bonds over a 1-2-year horizon. With the economic fundamentals turning around, we think that potential for material stress in corporate balance sheets is low. In addition, during the pandemic, non-banking finance companies (NBFCs) have pruned their balance sheets and improved liquidity and capital. Therefore, there could be a meaningful opportunity in investing in these issuers to take advantage of the higher yields, especially in the shorter tenor (1-2 years).
In the non-AAA segment, there is a significant yield differential between different issuers within the same rating class depending on parentage, asset class and governance structures. Hence, adequate due diligence on the names will help understand the risk profile and will benefit in taking a calculated risk.
Ajay Garg is Managing Director, and Anitha Rangan is Economist at Equirus .
DISCLAIMER: Views expressed are the author's own, and Outlook Money does not necessarily subscribe to them. Outlook Money shall not be responsible for any damage caused to any person/organisation directly or indirectly.