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Is India Staring Down The Barrel of Stagflation?

by Tavaga Invest
Is India Staring Down The Barrel of Stagflation

By: Tavaga Research

The Indian economy was already confronting a contractionary state of affairs just before the disruption of the global economy, which kicked in as a result of pandemic-induced situations. The situation, if incessant, may be heading toward a period of stagflation.

What is Stagflation?

Stagflation is a macro-economic situation characterized by increasing inflation, high unemployment, and negative or stagnant economic growth. Conventionally, high inflation is an indicator of a growing economy as the demand pushes the prices of products and services. To sustain flourishing demand, purchasing power is essential. Purchasing power is prevalent when the economy is performing on low unemployment. Moreover, low unemployment is a factor of growth in economic activity as the corporations seek to access the labor force to achieve potential expansion. Therefore, the three elements are interlinked and stimulate the economy by working in sync.

Following recent economic developments and growth highlights of the first quarter, the negative 23.9 percent Gross Domestic Product (GDP) growth has dented the prospect of a swift rebound. Inflation, resulting from supply-chain disruptions during complete lockdowns, is the latest of worries. The situation poses a dilemma for the Government.

General fixes to inflation and recession, which are diametrically opposite, involve altering the monetary and fiscal policies. To alleviate a recessionary economy, a Government aims to increase the money supply in the economy to boost public spending. On the contrary, inflationary pressure on the economy is subdued by restricting money supply, which means pushing borrowing rates to the higher side making money expensive. 

When did Stagflation Occur?

Stagflation was first acknowledged in the 1970s following an oil crisis. The crisis was sparked due to an increase in prices of oil after Organization of Petroleum Exporting Countries (OPEC) issued an embargo against the Western Countries. The rise in the price significantly affected the productive capacity of the economies.

As per the Keynesian school of thought, rising oil prices should have contributed to high economic activity. On the contrary, the United States in the 1970s suffered from rising costs, recession in economic activity, and rising unemployment all at once. It was then when Milton Friedman promulgated the monetarist theories which explained that oversight of money supply in the economy directly influences the rate of inflation.

How is Stagflation Addressed?

As per the theory, if inflation were to keep on rising, unemployment will witness a surge again as corporations will carry lay-offs unable to sustain increasing labor costs. Therefore, inflation is the first element that needs caution. Rightly so, the Government has changed its accommodative stance in terms of further RBI rate cuts in the latest Monetary Policy Committee (MPC) meeting. A rate cut is not anticipated in the near future.

The next step is to provide supply support to the economy by incentivizing the business to produce more. The inherent assumption here is that the demand-side has the ability as well as the desire to purchase.

Stagflation is known to correct itself over time. Especially in an outlier event such as the coronavirus pandemic, the elements are likely to return to normalcy without Government intervention. However, the matter of concern is demand revival which has been threatening the economy for the past two years.

How to Invest during Stagflation?

The way to generate or preserve wealth during stagflation is by routing your investments through securities that focus on yielding profits. Essentially, the investment assets which provide an internal hedge to inflation serve as the best prospects during these troubling times. 

Interest rates are unable to keep up with inflation during recessionary phases, suggesting that Government bonds or other money market instruments are rendered inefficient. Acknowledging the time value of money, which explains that the unit value of money today is worth more than tomorrow, the purchasing power of investments in low yielding securities lags behind inflation. 

Therefore, investing in stock markets is ideal given that the capital is deployed toward defensive sectors and the companies chosen have strong balance sheets offering growth potential. Gaining exposure by going long on sectors such as Energy, Consumer Defensive (food and utilities), Healthcare, and Utilities can prove beneficial to stock portfolios. These sectors over-perform during economic downturns as they pass on the rising costs to the consumers as reflected positively in sector turnovers.

An alternative to investing in the stock market is investing in commodities through direct purchase on the exchange or through Exchange Traded Funds (ETFs). The idea is to exploit the rising prices of the commodities instead of becoming a victim of it.

What is the Current Trend of Inflation, Unemployment, and GDP?

RBI set an inflation target band of 4-6 percent. As an outcome of this outbreak, the inflation rate has surpassed the tolerance level of the Central Bank. RBI has cut policy rates by 115 bps amid the pandemic to aid borrowing and survival. The inevitable expansionary stance has given way for inflation to surge. 

Unemployment data for August goes to show that after witnessing a recovery in July numbers, the unemployment rate has shot up to 8.4% from 7.4%. The rural economy has contributed primarily to this increase as the Kharif crop sowing season marked its end. Moreover, the Mahatma Gandhi National Rural Employment Guarantee (MGNREG) experienced a loss of work, unable to provide material jobs to the participating labor force.

Inflation vs Unemployment September 2019 - August 2020
*Inflation Data for August 2020 awaited | Source: Trading Economics, Tavaga Research

GDP Annual Growth Rate QoQ 2018-2020
Source: Trading Economics, Tavaga Research

The negative GDP growth of Q1 2020 is alarming in that the activity rate captured by the economic indicator is at its decadal low on the back of nation-wide lockdowns.

(For further information on takeaways from latest GDP numbers, click here

Factors Ruling the Bond Market

With increasing inflation in the backdrop, the real return for bonds has entered into negative territory. The yield for longer duration Government securities (G-secs) has been on an upward trajectory responding to the hawkish stance of RBI.

To help ease the volatility in the bond market, the Reserve Bank has announced Open Market Operations (OMO) to the tune of Rs 20,000 crores in two tranches, Rs 10,000 crores for each tranche, simultaneously buying longer-term bonds and selling short-term bills. Indian bond yields relaxed following the announcement of stability measure as they touched their low of two weeks. The operation is also intended to lower the differential gap between long-term and short-term maturities of G-secs.

G-SEC Return September 2019 - August 2020
Source: Investing.com, Tavaga Research

(Note: Bond prices move in the opposite direction of bond yields. An increase in bond yield pushes the bond prices lower)

The bond market is facing the pressure of stagflation as the fiscal deficit is also closing in on double the budgeted rate of 3.5% of GDP. Bond markets directly affect the borrowing cost for corporations thereby restricting production output.

In light of the points articulated, stagflation risks appear to be transitory. An uptick in the economic activity shall ostensibly normalize the adverse health of the nation’s finances. A spur in demand and an inflow of investments is the need of the hour.

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