Financial markets have been quick to identify a questionable “ Fed Pivot” to validate recent price actions and reinforce the “Recession trade“. The US FED delivered a 75 Bps hikein Julythat was largely expected, notwithstanding fears of even a larger movepost the latest CPI data for June 22. The FED has joined most other central banks that have rightly refrained from providing explicit forward guidance on the path of future policy rates while reinforcing the broader policy objective in the current context, i.e getting inflation back under the mandated 2% target. Considering a relatively faster pace of rate hikes since lift off in March 22 and with policy rates at 2.25% -2.50%which seems close to neutral zone, it is quite logical to assume that incremental hikes may not be of similar magnitudein every policy. That definitely does not preclude rates moving further into a more restrictive range if inflationoutcomes and expectations warrant it.

Comments that seemed to confirm a more measured and data dependent approach on the magnitude of further actions in futurepolicymeetingsseemed to validate an emerging theme on a turn in the FED stance. A one sided market narrative/ positioning hasled to further mark downs in the terminal rate as well as reinforcing hopes of rate cuts into CY23.

Source: Bloomberg

Financial markets have been conditionedrepeatedlytothe “Central Bank PUT”,(where policy easing/QE/dovish guidance comes in at the first signs of market frictions/growth slowdown )ever since the 2008 financial crisis and have probably been anchored to the same template in recent times. The moot difference is that all alongover this timeframe, central banks have been helped by a deflationary era where inflation stayed much below targets. It is not so far back that the US FED adopted an Average Inflation Targeting framework to anchor inflation closer to 2% on an average. However, the current phase of potential demand slowdown has been marked by persistent inflation way above targets and a healthy labour market amid signs of second order effectsof elevated inflation. The geo political backdrop adds anadditional layer of vulerability.

Elevated and persistent inflation that leads to demand destruction and reasonably fast, though belated catch up in policy rates alongside an exit from QE policies have definitely set the stage for demand slowdownas financial conditions tighten at the margin. The decline in globalmoney supply also provides a favourable backdrop. The “bullwhip effect” in supply chain in goods that arise from rapid shifts in supply and inventories as end user demand swings from excessto moderatecould alsolead to downward adjustment in goods prices. At the same time, sharp loosening in financial conditions as markets overextend, could negate the very effects of policy tightening.Asmarkets start to reprice expectations of policy loosening , one could expect continued volatility in markets.While inflation could head downwards in the backdrop of growth concerns, it may require higher policy rates/ tighter financial conditionsfor a bitlongerto bringthose within the targetsas well as anchor expectations.

Equity

The past month saw risk assets including equities make a strong comeback after several months of weakness. The move was primarily driven by markets beginning to believe in the ‘peak inflation’ narrative. The fall in commodities especially crude has helped fortify this narrative and has also led foreign investors to look at commodity importers like India more favorably. We have been talking about it for a while, that a sharp decline in global money supply growth should eventually lead to a decline in inflation. That the market has now begun accepting this is in line with our expectations. However, we do think that just as slowing global money supply is likely to lead to disinflation, it also will have an impact on global growth. To that extent while the decline in global yields provide support to equity valuations, economic sluggishness is likely to stay a headwind. This is especially true for outward facing segments of the economy even as global sluggishness is likely to have a ruboff on Indian growth as well. US yield curve is now decisively inverted and historically this has been a harbinger of recession.

US yield curve is decisively inverted

Source: SBIFM Research, Bloomberg

And the fact that the US Fed is still tightening (and shrinking the size of its balance sheet) in the wake of already low money supply growth only adds to slowdown risks.

Dipping money supply growth may mean lower inflation but also slower global growth

Source: : Bloomberg, SBIFM Research. Note: Approximated by adding up US, Eurozone and China money supply measures.

In this context, we believe it may be premature to declare an end to the current volatility. Investors should stay patient and stick to their long-term asset allocation. Just as potential disinflation had provided reason not to be overly pessimistic after the sharp decline, investors would do well to not get carried away after the recent sharp rally given the global growth risks.

However, patience through the turbulence is likely to be rewarded on the other side given that corporate earnings have likely turned the corner and are likely to trend higher over the next few years.

Earnings may be headed higher in the medium term even as near-term stays challenging

CMIE Economic Outlook, Bloomberg, SBIMF Research; *FY22 and FY23 earnings estimates are SBIMF

Fixed Income:

With no significant data release, domestic markets have continued to take cues from external developments with yields and market expectations on terminal rates getting repriced lower. Commodity prices, especially oil staying lower has been an incremental positive, even as a weaker rupee potentially offsets the positive impact to an extent. Activity based indicators point to reasonable traction in growth even as inflation settles higher than the upper band of the corridor. With inflation likely to have peaked at least in the near term, what is directionally important is the trajectory with respect to the policy target of 4% inflation, which has been completely absent both from the RBI and market commentary so far.

Source: Bloomberg

In this context, the RBI MPC statement and post policy briefings as well as the Governor’s statement have rightly prioritised inflation and external sector and financial stability. The policy hike by 50bps and continued stress on withdrawal of accommodation bode well from a medium term as well as near term perspective. The significant take away has been the RBI Governor’s statement as well as post policy briefing rightly emphasising the requirement to align inflation outcomes closer to the policy target i.e 4%. This has been in alignment with our expectation that, considering the positive trends emerging from domestic growth revival, the RBI would need to gradually condition expectations around the midpoint or the policy target of 4%. Recent market commentary as well as past RBI guidance had probably reset comfort range (inadvertently) towards 6%. At the same time, a subtle hint towards discomfort with negative real rates should broadly condition expectations towards the terminal policy rate range in the current rate cycle. Assuming a forward estimate of average CPI around 5% in FY24, policy rates around 6%-6.25% probably should be a base case if one were to look at real positive rates. Recent RBI research papers (RBI Bulletin July 22) have estimated a range of real rates of around 0.8-1.0% in the Indian context.

Monetary policy actions in the current context of potential global growth slowdown, persistent elevated inflation, geopolitical uncertainties as well as capital outflows would require deft handling, more so for emerging markets. In this context, the RBI has rightly eschewed providing forward guidance as expected in some quarters, while showing resoluteness to ensure inflation moves lower to the target range first and then closer to the policy target. Alongside a gradual unwinding of surplus liquidity, this should set the stage for monetary and liquidity conditions to gradually evolve consistent with maintaining stable inflation and inflationary expectations. This provides us space to incrementally add duration from a more medium-term perspective. Volatility in rates markets, especially in the context of continuous repricing of policy rate expectations in overseas markets would warrant a staggered approach alongside adequate focus on liquidity.

As we have maintained earlier, policy rates moving closer to neutral, RBI emphasising the midpoint target of 4%, while being alert towards external sector stability were the key variables to provide more confidence. This has largely been met with the MPC meeting in August.

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

Financial markets have been quick to identify a questionable “ Fed Pivot” to validate recent price actions and reinforce the “Recession trade“. The US FED delivered a 75 Bps hikein Julythat was largely expected, notwithstanding fears of even a larger movepost the latest CPI data for June 22. The FED has joined most other central banks that have rightly refrained from providing explicit forward guidance on the path of future policy rates while reinforcing the broader policy objective in the current context, i.e getting inflation back under the mandated 2% target. Considering a relatively faster pace of rate hikes since lift off in March 22 and with policy rates at 2.25% -2.50%which seems close to neutral zone, it is quite logical to assume that incremental hikes may not be of similar magnitudein every policy. That definitely does not preclude rates moving further into a more restrictive range if inflationoutcomes and expectations warrant it.

Comments that seemed to confirm a more measured and data dependent approach on the magnitude of further actions in futurepolicymeetingsseemed to validate an emerging theme on a turn in the FED stance. A one sided market narrative/ positioning hasled to further mark downs in the terminal rate as well as reinforcing hopes of rate cuts into CY23.

Source: Bloomberg

Financial markets have been conditionedrepeatedlytothe “Central Bank PUT”,(where policy easing/QE/dovish guidance comes in at the first signs of market frictions/growth slowdown )ever since the 2008 financial crisis and have probably been anchored to the same template in recent times. The moot difference is that all alongover this timeframe, central banks have been helped by a deflationary era where inflation stayed much below targets. It is not so far back that the US FED adopted an Average Inflation Targeting framework to anchor inflation closer to 2% on an average. However, the current phase of potential demand slowdown has been marked by persistent inflation way above targets and a healthy labour market amid signs of second order effectsof elevated inflation. The geo political backdrop adds anadditional layer of vulerability.

Elevated and persistent inflation that leads to demand destruction and reasonably fast, though belated catch up in policy rates alongside an exit from QE policies have definitely set the stage for demand slowdownas financial conditions tighten at the margin. The decline in globalmoney supply also provides a favourable backdrop. The “bullwhip effect” in supply chain in goods that arise from rapid shifts in supply and inventories as end user demand swings from excessto moderatecould alsolead to downward adjustment in goods prices. At the same time, sharp loosening in financial conditions as markets overextend, could negate the very effects of policy tightening.Asmarkets start to reprice expectations of policy loosening , one could expect continued volatility in markets.While inflation could head downwards in the backdrop of growth concerns, it may require higher policy rates/ tighter financial conditionsfor a bitlongerto bringthose within the targetsas well as anchor expectations.

Equity

The past month saw risk assets including equities make a strong comeback after several months of weakness. The move was primarily driven by markets beginning to believe in the ‘peak inflation’ narrative. The fall in commodities especially crude has helped fortify this narrative and has also led foreign investors to look at commodity importers like India more favorably. We have been talking about it for a while, that a sharp decline in global money supply growth should eventually lead to a decline in inflation. That the market has now begun accepting this is in line with our expectations. However, we do think that just as slowing global money supply is likely to lead to disinflation, it also will have an impact on global growth. To that extent while the decline in global yields provide support to equity valuations, economic sluggishness is likely to stay a headwind. This is especially true for outward facing segments of the economy even as global sluggishness is likely to have a ruboff on Indian growth as well. US yield curve is now decisively inverted and historically this has been a harbinger of recession.

US yield curve is decisively inverted

Source: SBIFM Research, Bloomberg

And the fact that the US Fed is still tightening (and shrinking the size of its balance sheet) in the wake of already low money supply growth only adds to slowdown risks.

Dipping money supply growth may mean lower inflation but also slower global growth

Source: : Bloomberg, SBIFM Research. Note: Approximated by adding up US, Eurozone and China money supply measures.

In this context, we believe it may be premature to declare an end to the current volatility. Investors should stay patient and stick to their long-term asset allocation. Just as potential disinflation had provided reason not to be overly pessimistic after the sharp decline, investors would do well to not get carried away after the recent sharp rally given the global growth risks.

However, patience through the turbulence is likely to be rewarded on the other side given that corporate earnings have likely turned the corner and are likely to trend higher over the next few years.

Earnings may be headed higher in the medium term even as near-term stays challenging

CMIE Economic Outlook, Bloomberg, SBIMF Research; *FY22 and FY23 earnings estimates are SBIMF

Fixed Income:

With no significant data release, domestic markets have continued to take cues from external developments with yields and market expectations on terminal rates getting repriced lower. Commodity prices, especially oil staying lower has been an incremental positive, even as a weaker rupee potentially offsets the positive impact to an extent. Activity based indicators point to reasonable traction in growth even as inflation settles higher than the upper band of the corridor. With inflation likely to have peaked at least in the near term, what is directionally important is the trajectory with respect to the policy target of 4% inflation, which has been completely absent both from the RBI and market commentary so far.

Source: Bloomberg

In this context, the RBI MPC statement and post policy briefings as well as the Governor’s statement have rightly prioritised inflation and external sector and financial stability. The policy hike by 50bps and continued stress on withdrawal of accommodation bode well from a medium term as well as near term perspective. The significant take away has been the RBI Governor’s statement as well as post policy briefing rightly emphasising the requirement to align inflation outcomes closer to the policy target i.e 4%. This has been in alignment with our expectation that, considering the positive trends emerging from domestic growth revival, the RBI would need to gradually condition expectations around the midpoint or the policy target of 4%. Recent market commentary as well as past RBI guidance had probably reset comfort range (inadvertently) towards 6%. At the same time, a subtle hint towards discomfort with negative real rates should broadly condition expectations towards the terminal policy rate range in the current rate cycle. Assuming a forward estimate of average CPI around 5% in FY24, policy rates around 6%-6.25% probably should be a base case if one were to look at real positive rates. Recent RBI research papers (RBI Bulletin July 22) have estimated a range of real rates of around 0.8-1.0% in the Indian context.

Monetary policy actions in the current context of potential global growth slowdown, persistent elevated inflation, geopolitical uncertainties as well as capital outflows would require deft handling, more so for emerging markets. In this context, the RBI has rightly eschewed providing forward guidance as expected in some quarters, while showing resoluteness to ensure inflation moves lower to the target range first and then closer to the policy target. Alongside a gradual unwinding of surplus liquidity, this should set the stage for monetary and liquidity conditions to gradually evolve consistent with maintaining stable inflation and inflationary expectations. This provides us space to incrementally add duration from a more medium-term perspective. Volatility in rates markets, especially in the context of continuous repricing of policy rate expectations in overseas markets would warrant a staggered approach alongside adequate focus on liquidity.

As we have maintained earlier, policy rates moving closer to neutral, RBI emphasising the midpoint target of 4%, while being alert towards external sector stability were the key variables to provide more confidence. This has largely been met with the MPC meeting in August.

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