Will inflation sustain higher for longer?

The last several quarters have seen the RBI maintain an 'accommodative' monetary-policy stance, with inflation forecasts that remain within the mandated band - even as realised inflation and consumer expectations have risen considerably, and remain at elevated levels. India is not the only country witnessing inflation. After years of low or negligible inflation, developed markets are feeling the heat of rising prices, though economists continue to forecast a cooling-off as prices stabilise (see charts 'RBI household inflation expectations' and 'Strong global inflation now but receding next year').

Return to normal?
Two assumptions anchor the lower forecasts: (a) much of the price increase is on account of supply-chain disruptions caused by COVID and (b) commodity prices will stabilise or fall from current levels. Taken together, it makes the case for moderation going forward. But this may turn out to be a simplistic assumption.

Per forecast of Morgan Stanley, the G10 economies will likely close their output gap by 2022-2023. Consumer demand even now far outstrips the supply in the US, even as China's exports grow rapidly (see charts 'US consumer goods' and 'China exports').

This demand spike has led to an increase in the price of fuel and metals, both of which have witnessed reduced investment over years. Production increase is going to take a while as investments need to increase. These are also constrained by ESG concerns, leading to a scenario where high prices may sustain longer than anticipated. Port capacities are constrained and lead times are long for clearing cargo (see charts 'Harpex Container Shipping Rate Index' and 'US ISM Supplier Delivery Times Index').

It is not possible to simply increase production of commodities without significant investment in production facilities and this cannot be achieved overnight. Inventory levels of fuel and metals are low and even if production does increase to sustain the increased demand, it will be a while before supply catches up or outstrips demand.

Take the case of steel. Prices have moderated over the past few weeks, but that can also be attributed to slower demand from sectors like automobiles, which have been impacted by the lack of semiconductor supply. Latest commentary from semiconductor manufacturers suggests that supply is now back to normal levels. This could lead to an increase in auto production, putting upward pressure on steel prices all over again.

Employee activism has picked up
In many countries, payments to citizens on account of COVID have improved household finances to the extent that workers are unwilling to return to the workforce. In the US, in particular, relatively high unemployment is coupled with jobs going unfilled. Workers are demanding more wages for their services, and this at a time when services demand has yet to pick up since many economies continue to suffer from COVID-related lockdowns. A pick-up in services will occur as these restrictions are lifted.

Labour-union activity has picked up, with organised labour demanding - and in cases receiving - benefits that may not have been conceivable even a few years ago. In Australia, Hutchison Ports Australia agreed on a settlement after three years of negotiation (https://bit.ly/3l0hdcX). Some of the clauses agreed to are:

• Workers have the right to appoint up to 40 per cent of the workforce and the union can appoint another 30 per cent. Only 30 per cent is at the discretion of the management.
• Workers will receive five wage increases of 2.5 per cent each over the next four years.
• Operational rosters will drop from 35 hours per week to 30-32 hours per week and workers will be entitled to paid leave of 20 days for domestic violence!
• The agreement caps casual employees, prevents redundancies (workers cannot be fired during the term of the agreement) and has clauses against automation.

United Auto Workers (UAW) in the USA has reported several successful strikes in the recent months. The latest was the agreement at Deere & Co., where it received a 10 per cent immediate raise and $8,500 "ratification bonus" along with other benefits. Earlier in the year, UAW workers struck work at Volvo and secured better benefits. In November, Kellogg continues to face a month-long strike at four of its cereal plants in the US.

High liquidity and loose monetary policies have helped keep interest rates low while fuelling demand. Central banks are unwilling to tighten even as indications of inflation over-reaching their targets abound. With labour markets turning tight, an overshoot on inflation cannot be ruled out.

Are earnings forecasts overly optimistic?
While consumer prices are rising, producer prices have galloped. In India, the gap is an unprecedented 640 basis points. This indicates a manufacturing sector struggling to pass on price increases to customers. This is not restricted to India alone (see charts 'India net profit margin vs PPI (WPI) less CPI' and 'Global net profit margin vs PPI less CPI').

Despite this, analysts continue to forecast increasing margins and earnings increase. Over the past decade, analyst estimates have had to be toned down meaningfully every year as initial bullish forecasts meet the reality of performance. The current year may see strong earnings growth on the back of performance of metal stocks and banks (as the NPA write-offs ease). However, to expect a repeat would require sustained increase in metal prices (which does not then square with benign inflation projections) and rapid increase in credit growth, which continues to remain tepid. It is likely that estimates for FY23 and beyond will again need to be tempered down.

Despite unprecedented bullish predictions, the Indian market continues to trade at a premium to its history as well as in comparison to other emerging markets (see charts 'India cyclically adjusted P/E' and 'India ROE and P/B relative to emerging markets').

At over 31 times cyclically adjusted P/E, the Indian market trades at significantly over one standard deviation of its 18-year average. Emerging markets trade at a discount to their 24-year average. Using ROE and P/B as metrics reveals a greater dissonance. While Indian corporate ROE has consistently fallen over the past two decades compared to emerging markets, the price-to-book ratio has remained largely constant. India trades at thrice China's P/B, and over twice its EV/EBITDA, EV/sales and P/E ('EV' means enterprise value).

Overall, the set-up of high earnings estimates, high relative valuations and cyclically high margins leaves open the potential for multiple negative shocks. The RBI has started to reduce excess liquidity in the system - thus far by suspending its G-SAP (Government Securities Acquisition Programme).

Though negative for equities in the near term, this in itself is not enough to spook the market. A global event is more likely to prick the rally than anything that occurs in India. That said, prudence demands a lower allocation to risky assets - particularly those where free cash flows are way out in the future on assumptions of rapid and sustained growth in the near term.