The Coming Collapse of Inflation & How to Benefit From it?

Commodity prices are falling, which is the biggest driver of inflation. The ‘Yield Curve Inversion’ and the trajectory of rates are Market indicators pointing to a slowdown ahead, which will put a damper on costs. Inflation in India, which was driven by food and fuel, is peaking and is probably going to fall.

A combination of weakening demand, improving supplies, a mean reversion in commodity prices, and “Base Effects” is likely to cause inflation to peak within the remainder of 2022.

What will benefit: Restricted duration plays, commodity users such as auto, cement, and consumption. Banking will play a role as disposable incomes rise and demand for credit strengthens further. But there are risks to the current hypothesis.

What Could Go Wrong with This Hypothesis?

According to this hypothesis, the greatest risk is a flare-up in Russia-Ukraine tensions that spills over into NATO. This might cause a sustained period of high and rising energy prices. Continued demand-side strength leads to higher inflation. The slowdown being witnessed across many advanced economies is without a meaningful reduction in work. This augurs well. However, this could result in a more resilient consumption trend than anticipated. This might delay the cooling off of core inflation pressures within the economy.

Up to now, China has given measured doses of stimulus to revive its economic process post the COVID-induced lockdowns. Although it is an occasional probability event, a mega stimulus from China can revive global growth and might have a powerful impact on commodity prices, delaying the mean revision in inflation.

Why is inflation probably going to chill?

• One of the largest drivers of inflation — commodity prices — is now falling. Most agricultural “softs” are down year to date, and the Agri index is down nearly 35% when compared to inflation.
• Fiscal and monetary stimuli are now in effect. Wage pressure is probably going to dissipate as the stimulus ‘Sugar Rush’ ends. This is often likely to contribute to a reversal in one of the core inflation drivers, especially in the US, the housing market.
• The US housing market is so hot that it’s “too hot”. Prices are rising at the fastest rate, with rental vacancy at a very low 6% and housing inventory at a very low 2.2 months of supply. At the same time that new home sales have begun to slow, new housing starts are now contracting sequentially.
• Housing contributes 42% of the US CPI inflation. This is likely to be a significant source of disinflation in the US in the coming quarters. What’s more important, could a reversion to mean in US housing will impact not just inflation in the US but demand for a good type of raw material, which is causing inflation globally. US real estate contributes 18% to US GDP and about 4.5% to global GDP. It’s the elephant in the room.
• In India, inflation has been more well-behaved than the global inflation trajectory. Domestic food prices and a delayed recovery helped India to avoid whole-number consumer price inflation. Now with Agri prices cooling off (food and beverages contribute 48% to India’s CPI), the inflation trajectory in India appears to have peaked.

Source: Bloomberg, Data As of June 2022

The Policy Wheel Is Inclined Towards Inflation Control

• There’s a coordinated fiscal and monetary policy attack on inflation.
• Measures by the government such as cutting excise duties on petrol and diesel have limited the pass-through of elevated global prices to domestic consumers.
• ‘Transport and communication’ inflation sequentially eased in June and will ease further in July when the policy support has seen a full pass-through.
• Also, the measures on windfall tax were passed to boost domestic supply and keep domestic prices in check. Monetary policy, on the other hand, is raising rates and has shifted the focus to tackling inflation expectations. If the RBI raises interest rates to 90 basis points and long-term inflation is 5%, the repo rate is likely to be in the 5.75–6% range.
• The RBI also recognizes that 12% of all CPI inflation is imported, so INR protection is aligned with inflation control. While the INR is making fresh lows now, we believe it could turn soon, possibly triggered by FII inflows restarting.

Now, how to benefit from it?

Banking/Lenders: Banks enjoy a strong business environment when demand for credit is strong and they are able to price loans better. Currently, banks are in good health with a clean balance sheet and adequate provisions ( with large banks ) reporting 80% or higher provisions. Moreover, on an aggregate price-to-book basis the large banks are trading below 2 times making them attractively priced. Rising credit growth and a possibility of better NIMs as investments move to loans could augur well for Banks.

Autos: Sharp increase in commodity prices lead to a need for 8–10% increase in vehicle prices in the last few quarters. This is much higher than the usual 2–4% price hikes cos take annually. OEs could only pass the cost increases partially and are currently seeing margins that are 200–400 bps below long-term averages. The falling commodity prices will definitely be a much-needed relief both for the OEMs and end consumers — OEMs could see their margins recover and the risk of consumer demand disruption from unprecedented price hikes reduces.

Cement: Higher fuel prices (pet coke, coal, and diesel) have hit sector profitability massively in the last couple of quarters and are likely to hit more going ahead. Market leader Ultratech Cement has seen its EBITDA/ton fall from ~Rs 1500 to Rs 1100 in the last four quarters; companies are indicating that there would be an impact of another Rs 200+ per ton in Q2FY23. This clearly indicates companies are finding it difficult to pass on cost increases to consumers in a very high inflationary environment. Correction in prices of the fuel basket would be like manna from heaven for the sector.

Consumption: While higher prices leads to revenue expansion of consumption stocks, the volumes soon start to contract. The current inflationary bout wasn’t reflecting robust demand, wage pressure continues and the state of rural economy can at be termed as modest. Consumption companies have been unable to pass on the increased prices and in fact, the narrative of “shrink-inflation” has been common. Lower inflation will fuel discretionary expenditure, help the volumes, and will keep growth and sentiments positive.

Global Technology: Over the last one year technology has seen a large de-rating in multiples and a loss in earnings momentum. The ultra-high growth period of post covid boost is unlikely to return but with the technology sector back to long-term average valuations, there is opportunity. Global technology and innovation-based companies have been able to grow their earnings at ~16% to 18% CAGR over one and half decades. This trend of heightened technology spend is here to stay. Lower inflation will support the growth-oriented technology sector though a decline in interest rates.

Author : Ekansh Hinger

References :

1. “In Japan, a Countryside Home Could Be Yours for Under $500" https://www.architecturaldigest.com/story/japan-countryside-home-could-be-yours-under-500
2. Sahil Kapoor on Twitter: “The Coming Collapse of Inflation” https://mobile.twitter.com/SahilKapoor/status/1547525013129273344
3. The coming Collapse Of Inflation & How To Benefit From It — www.dspim.com