The “Goldilocks” scenario of a durable economic recovery along with low and stable inflation that ensures continuing central bank support remains a key supportive narrative for financial markets. Supporting this hypothesis is the belief that the current surge in inflation proves transient, with slack in labour markets preventing a wage- price spiral or a durable pass through of wholesale prices into consumer inflation prints. With most global central banks likely to remain patient in even contemplating stimulus reduction, the vulnerability of markets to any abrupt shift in policy moves driven by data surprisesremains a key risk factor. With policy making increasingly based on an “outcome based” approach rather than“forecast based”, the risk of market volatility driven by changing expectations becomes more prominent.

The process of policy normalisation has been initiated by a few EM central banks such as Brazil, Mexico, and Russia in the recent past. This has largely been in response to emerging inflation risks, with CPI inflation printing above policy targets. Pre emptive policy actions considering the emerging risk factors by a few EM central banks stand in stark contrast to the policy framework adopted by developed markets as well as a few large EM’s.

Source: Bloomberg, SBIMF Research: Mexico’s central bank had reduced the rates by 25 bps in Feb-21 which got reversed in June-21

Equity:

Even as headline indicesregistered only modest gains in June rising about 1%, broader markets continued with strong outperformance, with midcap and small cap indices gaining 3.6% and 6.9% respectively. Hope of economic normalization as the second wave recedes and continued strong showing by corporate India in the results season helped. The government announced a relief package to help alleviate the distress caused by the second wave. Monetary policy on the other hand stays pro-growth. At a time when economic growth has likely troughed, profits for listed corporates as proportion to GDP appear to have troughed too. This was reflected in FY21 numbers as profits for Nifty companies grew in high teens even as GDP contracted 3% in nominal terms. A normalization in GDP as well as profits to GDP, from their respective troughs, could mean non-linear uptick in earnings over the next few years. Yet in the near term, how well we vaccinate and fight the virus, as well as how soon do consumer and corporate sentiments revive is going to dictate the pace.

Globally, the key near term worry for emerging market investors appears to be the nasty prints on inflation, and the potential withdrawal of monetary policy support on an incremental basis. In the recent FOMC meeting, the US Fed suggested that they have started a discussion on tapering their asset purchases, even as whether, when, and to what extent they will do it will depend on incoming data. For the time being with global central banks pushing back against any immediate normalisation, the markets seemto have reconciled to the view that the current demand rush in the western economies is driven by one-off benefit transfers during the pandemic and therefore should moderate as unemployment still stays elevated. Supply disruptions should wane too as economies reopen, enabling consumer price inflation prints to head lower. In the medium term, spends centred around infrastructure such as the ones proposed in the US infra bill should aid employment and lead to steady rise in growth and inflation.

Yet at a time when our in-house equity market sentiment measure suggests overheated sentiment, and which to us has been the key tactical risk, taper fears can potentially bring about volatility. This could be especially pronounced in pockets with speculative excesses. We would however recommend using any such corrections to add on to good quality pro-cyclical assets and stocks to position for the next several years of likely uptick in economic activity and corporate earnings in India.

Fixed Income:

The risk of incremental data surprisessharply resetting market expectation, thereby leading toan abrupt move in yields was evident in the debt markets last month. The latest CPI reading (for the month of May 21) at 6.30% y-o-y, came sharply above all consensus estimates and beyond the 6% upper band targeted by the central bank. The increase in CPI was broadbased across most segments with the core inflationremaining even higher led by sharp sequential increase in non-transportation related segments. While there may be potential data quality issues in the month (on account of reduced sampling due to lockdowns), the broad-based pick up remains worrying and from a market perspective, this has had the effect of resetting expectations and forecasts. The unanticipated pick up in the recent CPI reading has started to reflect in most future estimates of CPI and could very well flow into that of the central bank.

The elevated wholesale prices led by commodities and its pass through into retail prices remains the key monitorable. The absence of material demand side inflation at present remains a redeeming feature as of now, which was the basis of RBI’s benign outlook on inflation risks in the last policy meeting in June. However, the pass through as demand startsto normalise and services sector activities pick up is uncertain.

The price action in markets post the CPI print has been quite sharp with the benchmark 5 y sovereign bond moving up by about 25bps and the 14y security by around 15 bps, with a flattening of the curve. Corporate bonds too reflecteda similar directional price action. The price action in the 10y benchmark reflects the RBI’s heavy influence in one security. Interestingly, the latest market data for the last week of June, points to the benchmark 10y government security not being among the top 5 traded securities. This reflectsthe increased divergence in the market signalling intended by the central bank and the actual price signals as reflected in market pricing.

Continuing unsterilised liquidity intervention including through GSAP, accommodative policy stance and expectation of contained CPI readings within the target bandhave been the important narratives supporting the markets over the last few months. This was reaffirmed post the last RBI policy review when the RBI chose to completely sideline any potential inflationary risks. However, data surprises on CPI and the probability of its near-termpersistence is a materialrisk that is more glaring in the Indian fixed income markets. While fiscal policy has focused on long-term supply-side measures and credit guarantee schemes with only moderate immediate spending, the sharp drop in government revenues has led to large general government deficits and expanded public debt/GDP ratios. From a macro balance sheet perspective, the fiscal deficits and relative inflation remains a weak point, while the external sector remains robust

Unlike most global central banks which have faced persistent undershoot of targeted inflation and in some cases have a framework to explicitly allow period of overshoot, the RBI faces the challenge of supporting economic recovery in a situation where inflation could test the upper band of target along with excessively surplus liquidity and no clear unwinding road map. Most estimates of a delayed adjustment is predicated on the assumption that a gradual and non-disruptive unwinding is possible as recovery is well established. Experience of the previous period of excess monetary accommodation post the Global financial crisis does not provide sufficient evidence of this. This is another vulnerability that is likely to manifest soon.

With the policy focus remaining on growth, policy rate adjustments are ruled out. What would remain the first line of adjustment would most likely be the unwinding of surplus liquidity, the buildup of which may not be consistent with the evolving macro backdrop. The timing for the same could well be earlier in this fiscal than later.

Data Source: Bloomberg, SBI MF research, CCIL

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The debate surrounding the long-awaited revival of inflation and its implications on monetary policy settings has re emerged in recent times. At the same time, global central banks have so far firmly resisted any discussions about unwinding the extraordinary support measures. Central to the cautious approach has been the experienceof the years since the global financial crisis, wherein developed markets central banks have consistently failed to achieve the 2% inflation targetinspite of large monetary accommodation and unconventional policy measures including large scale asset purchases. At the same time, there remains the challenge in terms of disentangling the “durable” from the “transient” elements in the current phase of inflationupswing considering the pandemic induced supply shocks.Central Banks such as the US FED have also made material changes in their policy framework that allows an overshoot of inflation over the target.

The wedge between wholesale and consumer prices have been evident across most geographies. Higher commodity prices have fed into higher producer prices globally. US PPI inflation surged to 6.2% in April (vs. 2.8% two months ago). China posted 6.8% (vs. deflation through 2020). Indian WPI, proxy for producer prices, surged to 10.5%. This has not been passed onto consumer prices to similar strength and extent.

Until around 2013, there was a reasonably close correlation between headline CPI and PPI inflation. However, this has changed over the last seven-eight years: the correlation has weakened. What accounts for this is hard to say, but structural changes are likely at work, such as increased competition within industries that limit the pass-through from higher producer to consumer prices. Therefore, the latest spike in the PPI, largely driven by higher commodity prices, has not fed entirely into a major surge in consumer prices. Within consumer prices, the momentum appears to be faster for developed market economies vis-a-vis emerging market economies, as the former sees demand support from fiscal stimulus and faster vaccination. Emerging market economies, on the other hand, have a relatively contained Consumer price inflation (compared to their own history).

Source: SBIMF Research

The overwhelming presence of large fiscal stimulus apart from the recent trends of supply chain realignment and increasing use of tariffs present a new dynamic to monitor with respect to its impact on long term inflation formation. Whether these represent a turning point in the inflation cycle is yet to be known. However, given the role of low interest rates supporting asset prices, how central banks respond to signs of any durable pickup in inflation in terms of “tapering” the support currently being provided is crucial to monitor.

Equity:

Indian equities had a strong month as the Nifty and the Sensex surged about 6.5% apiece with the former recording fresh all time high and the latter in touching distance of it buoyed by moderation in Covid infections. Covid cases peaked in early May and continued to see a significant reduction through the month. Not surprisingly the up move has been led by pro-economy segments with Financials, Small caps, and Services and hospitality outperforming. There were other supportive trends at play too as global yields stayed moderate, the dollar weakened, and Emerging Market equities found a bid again. The ongoing result season has been strong as expected with the Nifty companies having reported so far suggesting nearly 18% and 40% year on year growth on sales and operating profits respectively off a weak base. The year hasshaped up well too with net profit for Nifty rising in high teens. In a year when the economy contracted by 7.3% on a real basis and 3% even in nominal terms, this growth in earnings is quite remarkable and supports the thesis that corporate profits to GDP in India may finally be reverting higher after having plunged to multi-year lows.

A key factor driving profits for corporate India this year has been a significant expansion in margins driven by cost efficiencies. While some of the cost may come back as operations resume in full swing and raw material prices continue to see upward pressure, on the other hand as growth normalizes, operating leverage benefits should kick in and support margins. In addition, several sectors that have adversely impacted corporate profits over the past few years such as corporate banks, telecom, and metals appear to have turned the corner. Policy backdrop continues to be extremely favourable. Aggressive fiscal expansion in addition to super accommodative monetary policy in the West, most notably the US, should augur well for a reflation in the global economy. Stronger balance sheets for banks, healthier corporate balance sheets, leaner cost structures and reforms around formalization of the economy, corporate taxes, PLIs, GST, real estate, etc augur well. We therefore continue to believe that we are in early stages of a new earnings cycle.

Yet the path, at least in the near term, is unlikely to be linear. While the worst of second wave appears to be behind, how long does it take for the scars of the crisis to heal and how quickly does consumer and corporate confidence return on the other side of the current crisis is still a question mark. Distress in the unorganized sector and unemployment have soared. Whether and to what extent can the government provide fiscal relief to dampen the impact is yet to be seen. The progress on vaccination is another key monitorable as that will determine the true extent of reopening as well as the probability of another harsh wave. Globally, rates and dollar have stayed benign so far, even with rising inflation prints as central banks as well as markets see these as transient. However, continued high inflation prints may cause near term jitters. Above all, the most important near-term risk in our view comes from an elevated reading on our proprietary equity sentiment index which suggests overheated sentiment and may limit upsides in the short term. However, given our positive structural view, we continue to see any tactical corrections as welcome opportunities to add proeconomy assets and stocks.

Fixed Income:

The RBI’s GSAP auctions and the continuing implicit yield curve control strategy has kept the benchmark 10y sovereign bond yield anchored around 6% in the recent period. This has come at the cost of the cumulative fiscal year to date gross dated securities borrowings being lower by around Rs 180 bn over the notified amounts. The RBI has had to reject auction bids/ devolve auctions on Primary dealers in its endeavour to hold the benchmark around 6%. Large cash balances from the previous fiscal year as well as a larger than budgeted surplus transfer by the RBI have provided sufficient cushion for the same in Q1 FY22. The RBI surplus transfer amounting to Rs 991 Bnis higher than the budgeted amounts by around Rs 450-500 Bn. At the same time, the impact of the second wave on overall government finances, both on the revenue side as well as additional expenditures is uncertain currently. Alongside the supply side reform measures and additional Government capex that has been budgeted, there may still be a case to provide more targeted income support or fiscal relief to mitigate the economic and social impact of the pandemic. The provision of additional liquidity or monetary policy support may be incrementally less effective and potentially create issues with respect to asset market distortion and financial stability.

In this context, the central bank would find it extremely challenging to hold the line on bond yields in the absence of robust natural demand at levels targeted so far. Additional GSAP / other market interventions would remain a necessary requirement for a while. While the overall indirect taxes had shown steady growth since the second half of FY21, the impact of recent regional lockdowns on account of the second wave could lead to a slowdown in Q1FY22. The gap between protected revenues to states and the compensation cess collection is likely to be bridged through market borrowings intermediated by the central government as in the previous fiscal year.

From a market perspective, the continuation of excessively surplus liquidity and ongoing RBI intervention remains important to support or validate the existing market levels and credit spreads. This remains a key vulnerability factor. The market reaction in January 20 after the RBI initiated the resumption of the revised liquidity management framework through 14D reverse repo auctions is sufficient evidence of the potential vulnerability.

As the second wave subsides and activity levels start to normalise, there would sufficient reasons to start the normalisation of crisis era liquidity and monetary support. The liquidity impact of interventionsin Government securities market, that may still be required in view of the larger borrowing requirements, may at the margin needs to be sterilised. Incremental GSAP auctions from the second quarter may well be accompanied by longer term variable rate reverse repo auctions. This may provide a signal for a gradual normalisation of money market rates away from the reverse repo floor.

Data Source: Bloomberg, SBI MF research,

Mutual Fund investments are subject to market risks, read all scheme related documents carefully.