Market surges as inflation cools

Abundant global liquidity and brightened prospects for another interest rate cut have driven shares in India to their highest in more than two years, and the rally could further pick up steam with mild corrections along the way.

A drop in world commodity prices has cooled inflation pressures, providing elbow room for the hawkish central bank to lower borrowing costs and shift its focus to reviving growth in the nearly $2 trillion economy, Asia’s third largest after China and Japan.

The wholesale price index, India’s primary gauge for inflation, rose 4.89 per cent in April from a year earlier — the slowest annual rise since November 2009 — and dropped within the Reserve Bank of India’s comfort range for the first time in more than three years.

RBI Governor D. Subbarao, who has steadfastly followed an iron-fisted monetary policy citing price pressures as his biggest concern, said he was “very happy” and added that the central bank would “take note of softening inflation” and future policy-setting meetings.

His comment lit a fire under the market and propelled the top-30 Sensex to its fifth consecutive weekly gain. The widely tracked stocks benchmark jumped to 20,286.12, its highest close in 2-1/2 years. It has gained four per cent in May, and a strong 11.2 per cent since the week ended April 12.

Investors should consider taking some profit off the table as current valuations at about 15 times 2013-14 earnings were near the long-term average, said Sanjeev Zarbade, vice president of private client group research at Kotak Securities.

“However, from an investment perspective, the Indian equities hold long-term potential and market corrections should be looked at as an opportunity to buy,” he said. “The recent fall in gold prices if sustained has the potential to spur financial savings from gold and fixed deposits into equities, a positive in our opinion.”

Rate cuts likely in June and July

Following the drop in the headline inflation rate, Bank of America-Merrill Lynch said it expected the RBI to lower the repo rate — the central bank’s main policy rate — by a quarter of a percentage point each in June and July. The forecast by the US investment bank was a major shift from its earlier stance of one cut in October.

The RBI has cut rates by a total of 75 basis points in 2013, the latest on May 3 which lowered the repo rate to 7.25 per cent. However, this was insufficient to help jump-start stagnant investment and consumer spending in the nation of more than 1.2 billion people struggling under higher food prices and chronic power shortfalls.

“We have added a second 25 bps RBI rate cut on July 30 after the one on June 17 to revive growth after April WPI inflation dropped to 4.9 per cent,” economists at BofA-ML wrote in a note to investors.

The RBI could pause after July to see whether inflation accelerates in the second half of 2013 due to planned increases in state-set prices of diesel, electricity and coal, it said.

The investment bank said it expects the RBI to cut the cash reserve ratio – the proportion of deposits that commercial banks must keep idle with the central bank — by 50 basis points in the second half of 2013. A reduction in the CRR, a long-standing demand of banks, from four per cent now would significantly lower lending rates.

BofA-ML said the RBI was likely to buy Rs1.6 trillion of bonds through open market operations in 2013-14 to help improve liquidity. It also expects the RBI to hold the rupee in a 52-56 range against the US dollar if the euro continued to trade in a $1.2 to $1.3 band.

Foreign investors upbeat, S&P cautious

Finance Minister P. Chidambaram, one of the few bright spots in the Prime Minister Manmohan Singh’s cabinet, has been ploughing a lonely burrow to nurse back government finances, woo foreign investment and revive growth that slowed to its weakest in a decade.

His policy initiatives, starting from opening up the supermarket sector last September to raising domestic fuel prices and slashing the government subsidy bill, have boosted the confidence of foreign investors.

Combined foreign portfolio investments in equities and debt have reached $18.5 billion so far this year, with inflows during May 1-16 at $3.8 billion, according to data from the Securities and Exchange Board of India. Foreign institutional investors, who were only allowed in two decades ago, currently own assets worth $177.3 billion.

For all the positive vibes that Chidambaram has managed to generate, he has been unable to pilot important reform bills such as opening up the pension sector to foreign investors through a dysfunctional parliament. This has caused some ease among rating agencies.

On Friday, Standard & Poor’s reiterated its negative outlook on India’s credit rating, which is one notch above “junk”, saying although the country’s position had improved over the past year, a high fiscal deficit and heavy government borrowing remained a drag.

It also said that New Delhi needs to follow through on reforms.

“We have indicated compared to one year ago, there is some easing of the pressure towards the downgrade of the rating,” S&P credit analyst Takahira Ogawa said on a conference call.

“But nonetheless there is still more than one-third of chance for downgrade unless we see significant improvement of the factors that we mentioned,” he said.

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The writer is a journalist based in India