Target firms that can handle inflation better

The signals on the inflation front appear to rather confuse. But, inflation is more likely to rise than not. Global factors, namely higher First World growth, are creating an upwards trend in most commodities. Crude oil price has risen by 45 per cent in the last six months and it's likely to stay close to current levels or move higher. Industrial metals are up by 20 per cent in the last year.

A domestic component, food, which has a large weight in the Indian inflation basket, is showing discrepancies between wholesale and retail price indices. The WPI (Wholesale Price Index) food basket saw lower inflation in December, whereas the CPI (Consumer Price Index) food basket (which is a little different and has much higher weight) has seen rising inflation. Overall, retail inflation broke up beyond 5 per cent in December, with the CPI rising 5.21 per cent, year-on-year. But, wholesale inflation seems to have moderated somewhat, with the WPI dipping to 3.6 per cent year-onyear versus 3.9 per cent in November.

The Reserve Bank of India (RBI) will not cut rates anytime soon and may even be under pressure to hike policy rates, if crude prices remain elevated.

The central bank's calculations show that a sustained price of $65/barrel for crude could push up inflation by 0.3 per cent and reduce Gross Value Added growth by 0.15 per cent. The benchmark Brent contract is now trading at $69/barrel, the Indian crude basket is likely to be about $2-3 cheaper, it was $62-63 in December.

A rise in inflation and higher interest rates can, under some circumstances, bring relief to debt-laden corporates and lender-banks. One problem with low inflation is that it hits nominal growth in profits and revenues, and that makes debt repayment difficult. If higher inflation creates higher nominal revenue growth, it may be easier to service debt though it would be bad for the economy on several other counts.

But, the divergence in wholesale and retail inflation trends suggests industry lacks the pricing power to pass on cost increases. If that's the case, things could get worse.

The RBI's Financial Stability Report projects that bad loans and stressed assets should peak in September 2018. If corporates lack pricing power but inflation rises, margins would get worse. Then the NPA (non-performing assets) mountain might rise higher than anticipated and it may keep growing beyond the September 2018 deadline. Corporate results so far, indicate that Q3 was reasonably good. But, inflation has risen through that quarter. If it rises through Q4 and corporates cannot pass it on, results for the coming quarters will be badly impacted.

Extrapolations of trends in food, suggest that the CPI might moderate if food prices come down. The lower food inflation in WPI may translate into lower retail prices for food in January, which would help cool CPI. Even so, the RBI is unlikely to touch rates in February at the next Policy Review.

If India is headed into a high inflation scenario, we should look at corporates with lower working capital needs. Unfortunately, the GST (goods and services tax) has also pushed up working capital needs for everyone and we have to wait for the new tax system to stabilise before discounting that effect. Traditional wisdom suggests FMCG and services firms have lower working capital needs and tend to have lower long-term debt and hence, better debt-equity ratios as well. Cash flow based analysis also becomes very important in this scenario because reports suggest immense delays in GST tax credits and offsets. Will this lead to a moderation of the current euphoric market sentiment? That may or may not happen. But, the rational investor can factor in the trend of rising inflation, which will help in targeting corporates more likely to thrive in such a situation.

Corporate results so far, indicate that Q3 was reasonably good. But, inflation has risen through that quarter. If it rises through Q4 and corporates cannot pass it on, results for the coming quarters will be badly impacted