With food inflation for the week to December 25, 2010 turning out to be a bit of a shocker at 18.32%, thanks mainly to the soaring prices of vegetables, it?s unlikely now that inflation will moderate to levels of 5.5% by March as the central bank had projected. That could mean a sharper rise in interest rates sooner than anticipated and the question now is whether the Reserve Bank of India (RBI) may go so far as to opt for a 50 basis points hike in key policy rates when it meets on January 25. The stock markets, which were jittery even last week, with the benchmark Sensex giving up 4%, now seem to be bracing for a steep rise in interest rates. And the bond markets are more nervous than ever with the yield on the benchmark jumping to 8.2% on Monday, an eight-month high.
Corporate India must be worried too. Crude oil prices are at $90 a barrel and local inflation doesn?t show any signs of tapering off; companies would remember from past cycles that, after a point, high interest rates do impact spending. Rohini Malkani of Citigroup has projected a deceleration in the IIP for November from the 10.8% seen in October. Malkani says the increase in the IIP will slow down to 6.1%, taking into consideration the volatility in capital goods and seasonally-adjusted trends due to festival demand. Moreover, the growth in the infrastructure index, she points out, has slowed to an anaemic 2.3%. A 6 % growth in the IIP is far from robust though it?s better than the stunted 4.4% year-on-year growth seen in September. Again, corporate earnings for the December 2010 quarter are unlikely to disappoint investors although they will moderate: against a 45% year-on-year growth in consolidated earnings for the Sensex set of companies in the September quarter, CLSA estimates earnings will grow 25% in the December 2010 quarter. But all that?s in the past.
For 2011-12, the rise in Sensex earnings is estimated to be a more modest 19%. And while higher prices of commodities will boost Sensex earnings, they hurt user industries and impact earnings for the broad market, especially smaller companies. So, if the high prices of commodities sustains, it?s possible there could be earnings downgrades and the Indian market could start trading at a lower multiple, especially since the quality of earnings too would have deteriorated. Most important, companies need confidence to go ahead with their capacity addition plans and while some of that will come from the recovery in the global markets, the interest rate environment at home too needs to be conducive; interest rates do matter when it comes to large projects. Most engineering firms are sitting on large order books but projects need to get off the ground. Meanwhile, the consumption story shouldn?t suffer as much since farm incomes are likely to remain strong.
Already, India?s underperformance relative to both developed and developing markets has been huge over the last few months and more importantly, this has been driven not by global but domestic factors. While the Korean and Taiwanese markets have gained 11% and 7%, respectively, between October, 2010 and now, and the Dow Jones has risen nearly 9%, India has lost 6%. India was always more expensive than its peers; even after coming off it could remain dear if earnings don?t keep pace.