The markets fell 4% last week as s**t finally got real! The RBI increased rates by 40 basis points in a surprise, unscheduled announcement. The markets reacted negatively immediately, falling consistently after.
In the same week, the Fed increased rates by 50 basis points, and the US markets jumped up staging a ‘relief rally’. And the next day, it wiped all the gains off. What’s up?
It is time to get used to economic realities
Data and reality have been in front of us for a while now. For the last year, inflation has been rising; earlier because of a post-pandemic recovery, and supply chain bottlenecks, and later because of the Russia-Ukraine conflict, supply chain disruptions, sanctions, and a global demand-supply mayhem.
And while the inflation rate has been increasing for the last year, and central banks were talking about rate hikes and lightning of balance sheets, the RBI had maintained a pro-growth stance. It was only last month that a shift was seen in priorities from growth to inflation control.
And then came the unscheduled rate hike! The surprise stems from the sense of urgency the manner of announcement exhibited. But again, what else could one expect?
Petrol, diesel and gas prices have been increasing
Food prices globally are going up as Russia-Ukraine were major suppliers of so much from wheat to sunflower oil
Essential commodity prices too went off the roof
The cascading effect of cut supplies and sanctions rolled over to other substitute commodities too
Domestic shortages in supplying countries now is leading to protectionist moves, which have been further fuelling inflation
Inflation and corporate profits
Inflation is one of those topics, which is often looked at from a consumer’s standpoint, thanks to its effect on the general population and media coverage. However, the economic effects are far worse, and felt more indirectly. Here are some:
Input costs increase for corporates too. Take consumer companies for example. Costs have gone up for wheat, palm oil, packaging material and transportation, among other things. These costs can either be passed on in the form of higher pricing, or profits can take a hit.
When inflation is already hitting consumers, companies can’t pass price increases on to consumers fully. If they do, consumers will buy lesser, impacting revenue too. So companies, pass on some costs, take a little hit on revenue, and a large hit on profits.
Central banks increase interest rates to control inflation. When interest rates rise, companies pay higher interest on their debt, and their profits get hit.
When interest rates rise, future cash flows of companies get discounted at a higher rate. This leads to lower valuations at present.
Not good for the markets
In short, as an immediate impact of high inflation, and higher rates, corporate profits decline and so do valuations. The end result? Lower stock prices!
Be prepared to lose money in the short term as revenue growth slows down, margins contract, and valuations decline too.
But not everything will uniformly decline when the markets fall, because impact will be different at different places. So what are some relatively safer spots - defensive sectors, sectors less impacted by inflationary pressures, companies with positioning such that higher pricing can be passed on to consumers without much topline impact, sectors that have a lot of value-add and hence higher pricing power, companies with monopolies, value stocks, sectors that have other tailwinds like government spending, among others.