A subtle shift in major Global central bank’s policy stance has been evident over the last few weeks. A combination of continuing/ shifting “transitory” drivers of inflation apart from persistent supply shocks even as the global economy starts to recover helped by monetary and fiscal support and increased pace of vaccination worldwide, has brought back debates surrounding potential stagflation. There has also been a recognition that some of the drivers of inflation have remained more persistent and long lasting as against initial expectations. Recent flare up in natural gas prices and by extension into crude oil prices, while supply disruptions in semiconductors and logistics take longer to normalise reinforces the stickiness of headline inflation worldwide. However, recent monetary policy guidance by the FED has reinforced the difference between ‘tapering’ and ‘lift off’, with tapering likely to start as soon as this quarter. At the same time, the process of policy normalisation and sequencing of measures would be different and driven by specific economic dynamics, even as the directional shift to lesser accommodation needs to be accepted.

Pricing of risk assets based on expectation of ‘lower for longer’ are hence susceptible to repricing as the expectations on central bank support get dialled back. This has been fairly evident in the recent weeks and could remain a source of volatility going forward.

Source: SBIFM research, Bloomberg

Equity:

Indian equities continued their strong run both on an absolute basis and relative to global peers in September. The Nifty and the Sensex returned 2.96% and 2.78% respectively last month while broader markets staged a comeback too with the Nifty Midcap 150 index rising 5.92% and Nifty Small Cap 250 rising 5.76%. This came at a time when global investors continue to weigh in on the possibility of potential stagflation. On one hand, global growth appears to be moderating post the sharp reopening led uptick, with the Chinese economy and its real estate sector leading the slowdown. On the other, inflation due to supply side disruptions and exacerbated by geopolitics has continued to weigh too. In the near term, impact on demand and more importantly policy making is likely to be keenly watched by markets. While our view continues to be that global central banks are likely to normalize monetary policy in a calibrated manner to allow fiscal policy space to operate, the beginning of the process can still bring about volatility in financial markets. This risk becomes especially pronounced in the wake of stretched readings on our equity sentiment index for Indian markets and may keep volatility elevated in the near term and bring caution back.

From a medium-term perspective there is room to be more optimistic. Infrastructure spends from the West, especially the US if legislated should help pick up the slack from a slowing Chinese economy. On inflation, while part of it may stay, some of it is likely to abate as supply gets back as economies reopen. Market based inflation expectations for instance stay well anchored at the long end in the US. Importantly, after years of deflation, inflation can itself act as a trigger for more investments and hence an economic upcycle. For India, this inflection in global economic activity may be coming at a time when the country is already benefiting from market share gains in the global marketplace. This could be positive for a multi-year upcycle in both the economy as well as corporate earnings. Yet given the starting valuations at the headline index level, investors should do well to moderate their return expectations.

The bigger opportunity in our view is in asset allocation and security selection. The last decade had been all about deflationary assets as growth stayed anaemic, inflation globally was low, and rates generally stayed low. Within equities, stocks that offered safety and earnings visibility did well. Winners over the next few years however could look very different as economic growth and inflation both pick up. More generally, this would mean moving away from low-rate beneficiaries to pro-economy assets. Within equities, investors are likely to move focus on quantum of growth rather than just the certainty of it, which could present opportunities in high growth structural opportunities on one hand and select asset owners and quality cyclicals on the other.

Fixed Income:

Central bank guidance to markets on policy stance are typically communicated through Policy stance and actions, Monetary policy statements and periodic communication, which may be loosely called as Open Mouth Operations. While the last policy review and policy minutes did seem to suggest tentative steps towards normalisation, subsequent communication had pushed back against any such interpretation, with a very benign tolerance for sustaining the “large liquidity for a little longer”. However, over the last few weeks, at least RBI’s market actions and liquidity operations seem to suggest a change in assessment. While the RBI has continued to conduct short tenor VRRR (variable rate reverse repo) auctions outside of the scheduled 14D VRRR, the cut offs at these auctions have been on the higher side. At the same time, the pre announced GSAP auctions were converted to liquidity neutral Twist auctions. While Twist auctions clearly point to the discomfort with adding additional primary liquidity, the intent behind higher cut off, even closer to 4% in a 7 D VRRR auction can only be speculated to with respect to any signalling.

In this context, the forthcoming review provides the RBI, a clear window for communicating its guidance on liquidity normalisation. Being ambivalent about this would only lead to drastic back ended actions that would have larger dislocations with respect to markets. While the incremental actions on market intervention would take care of the flow factor, the stock of surplus liquidity would need more durable absorption beyond short tenor VRRR, ideally though market-based instruments. From a more structural perspective, increased usage of electronic payments would tend to mute the impact of currency leakage that provides a natural drainage for surplus system liquidity. The key challenges would be to unambiguously communicate that the crisis era liquidity conditions and shorter end rate settings aren’t the base case, and that normalisation would proceed gradually and secondly to clearly distinguish between tapering of liquidity support and monetary policy tightening / reversal. Given the current policy objective to nurture economic growth, any adjustment to policy rates seems pre mature at present and is unlikely.

From a market perspective, stronger government finances with an unchanged auction calendar remains positive along with news flow on Index inclusion that has led to pick up in debt flows in the recent months. Near term inflation readings would remain within the comfort range helped by base effects even as a more directional trend remains neutral with elevated core and wholesale inflation. Headline inflation is likely to temporarily head lower, but could eventually converge to core inflation, which has consistently remained above 5%. The phase of market pricing / direction supported by central bank actions seems to be past us and incremental direction would depend on how normalisation proceeds. Fixed income portfolio positioning would be more oriented towards being biased towards a directionally lower duration stance.

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

A subtle shift in major Global central bank’s policy stance has been evident over the last few weeks. A combination of continuing/ shifting “transitory” drivers of inflation apart from persistent supply shocks even as the global economy starts to recover helped by monetary and fiscal support and increased pace of vaccination worldwide, has brought back debates surrounding potential stagflation. There has also been a recognition that some of the drivers of inflation have remained more persistent and long lasting as against initial expectations. Recent flare up in natural gas prices and by extension into crude oil prices, while supply disruptions in semiconductors and logistics take longer to normalise reinforces the stickiness of headline inflation worldwide. However, recent monetary policy guidance by the FED has reinforced the difference between ‘tapering’ and ‘lift off’, with tapering likely to start as soon as this quarter. At the same time, the process of policy normalisation and sequencing of measures would be different and driven by specific economic dynamics, even as the directional shift to lesser accommodation needs to be accepted.

Pricing of risk assets based on expectation of ‘lower for longer’ are hence susceptible to repricing as the expectations on central bank support get dialled back. This has been fairly evident in the recent weeks and could remain a source of volatility going forward.

Source: SBIFM research, Bloomberg

Equity:

Indian equities continued their strong run both on an absolute basis and relative to global peers in September. The Nifty and the Sensex returned 2.96% and 2.78% respectively last month while broader markets staged a comeback too with the Nifty Midcap 150 index rising 5.92% and Nifty Small Cap 250 rising 5.76%. This came at a time when global investors continue to weigh in on the possibility of potential stagflation. On one hand, global growth appears to be moderating post the sharp reopening led uptick, with the Chinese economy and its real estate sector leading the slowdown. On the other, inflation due to supply side disruptions and exacerbated by geopolitics has continued to weigh too. In the near term, impact on demand and more importantly policy making is likely to be keenly watched by markets. While our view continues to be that global central banks are likely to normalize monetary policy in a calibrated manner to allow fiscal policy space to operate, the beginning of the process can still bring about volatility in financial markets. This risk becomes especially pronounced in the wake of stretched readings on our equity sentiment index for Indian markets and may keep volatility elevated in the near term and bring caution back.

From a medium-term perspective there is room to be more optimistic. Infrastructure spends from the West, especially the US if legislated should help pick up the slack from a slowing Chinese economy. On inflation, while part of it may stay, some of it is likely to abate as supply gets back as economies reopen. Market based inflation expectations for instance stay well anchored at the long end in the US. Importantly, after years of deflation, inflation can itself act as a trigger for more investments and hence an economic upcycle. For India, this inflection in global economic activity may be coming at a time when the country is already benefiting from market share gains in the global marketplace. This could be positive for a multi-year upcycle in both the economy as well as corporate earnings. Yet given the starting valuations at the headline index level, investors should do well to moderate their return expectations.

The bigger opportunity in our view is in asset allocation and security selection. The last decade had been all about deflationary assets as growth stayed anaemic, inflation globally was low, and rates generally stayed low. Within equities, stocks that offered safety and earnings visibility did well. Winners over the next few years however could look very different as economic growth and inflation both pick up. More generally, this would mean moving away from low-rate beneficiaries to pro-economy assets. Within equities, investors are likely to move focus on quantum of growth rather than just the certainty of it, which could present opportunities in high growth structural opportunities on one hand and select asset owners and quality cyclicals on the other.

Fixed Income:

Central bank guidance to markets on policy stance are typically communicated through Policy stance and actions, Monetary policy statements and periodic communication, which may be loosely called as Open Mouth Operations. While the last policy review and policy minutes did seem to suggest tentative steps towards normalisation, subsequent communication had pushed back against any such interpretation, with a very benign tolerance for sustaining the “large liquidity for a little longer”. However, over the last few weeks, at least RBI’s market actions and liquidity operations seem to suggest a change in assessment. While the RBI has continued to conduct short tenor VRRR (variable rate reverse repo) auctions outside of the scheduled 14D VRRR, the cut offs at these auctions have been on the higher side. At the same time, the pre announced GSAP auctions were converted to liquidity neutral Twist auctions. While Twist auctions clearly point to the discomfort with adding additional primary liquidity, the intent behind higher cut off, even closer to 4% in a 7 D VRRR auction can only be speculated to with respect to any signalling.

In this context, the forthcoming review provides the RBI, a clear window for communicating its guidance on liquidity normalisation. Being ambivalent about this would only lead to drastic back ended actions that would have larger dislocations with respect to markets. While the incremental actions on market intervention would take care of the flow factor, the stock of surplus liquidity would need more durable absorption beyond short tenor VRRR, ideally though market-based instruments. From a more structural perspective, increased usage of electronic payments would tend to mute the impact of currency leakage that provides a natural drainage for surplus system liquidity. The key challenges would be to unambiguously communicate that the crisis era liquidity conditions and shorter end rate settings aren’t the base case, and that normalisation would proceed gradually and secondly to clearly distinguish between tapering of liquidity support and monetary policy tightening / reversal. Given the current policy objective to nurture economic growth, any adjustment to policy rates seems pre mature at present and is unlikely.

From a market perspective, stronger government finances with an unchanged auction calendar remains positive along with news flow on Index inclusion that has led to pick up in debt flows in the recent months. Near term inflation readings would remain within the comfort range helped by base effects even as a more directional trend remains neutral with elevated core and wholesale inflation. Headline inflation is likely to temporarily head lower, but could eventually converge to core inflation, which has consistently remained above 5%. The phase of market pricing / direction supported by central bank actions seems to be past us and incremental direction would depend on how normalisation proceeds. Fixed income portfolio positioning would be more oriented towards being biased towards a directionally lower duration stance.

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