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Stock markets, globally, are highly correlated. The mother market, US, sets the trend and others follow. US market has turned weak: Nasdaq is down 30 per cent from the peak and S&P 500 around 19 per cent. The near-term dominant mood is bearish but the volatility is so high and, therefore, the market is swinging between risk-off and risk-on modes. In the near term, the market is facing too many headwinds.

Inflation has emerged as a major threat to economic growth and markets, globally. In the US, inflation touched 8.3 per cent in April, in the Euro Zone inflation is at 7.5 per cent and in the UK at 9 per cent. In India, CPI and WPI inflation prints have come in at 7.79 per cent and 15.08 per cent, respectively for April and is likely to persist at high levels for a few months more. This has negative implications for the economy in the short run.

A combination of factors has contributed to the rising inflation. Humungous liquidity created by the leading central banks of the world, particularly the Fed, supply chain disruptions caused by the widespread lockdowns in China and the spike in energy and commodity prices triggered by the Ukraine war have combined to produce high levels of inflation, globally. Central banks are tightening monetary policy; those who have not yet started tightening are expected to do so shortly.

The main question is what are the implications of high inflation and monetary tightening for stock markets? How should investors respond to this situation?

The Fed is on an aggressive monetary tightening path and the Fed chief Jay Powel has vowed to “raise interest rates till inflation comes down.” After the 50 bps rate hike in May, two more rate hikes of 50 bps each are expected in the next two FOMC meetings. Even though further Fed actions will be data-dependent, markets have factored in a terminal Fed funds rate of around 3 per cent in 2023. This has already impacted capital flows and currency markets. The dollar index has shot up above 103 and the US 10-year bond yield is hovering around 3 per cent. This is unfavourable for equity markets in the short run, more so for emerging market equities.

Like the Fed, RBI too proved to be behind the curve as evidenced by the MPC’s out of cycle rate hike of 40 bps on 4 May. More rate hikes are in the offing. Further rate hikes totalling 75 bps are likely in the June and August policies. This will impact economic growth in India. The RBI has already revised down India’s GDP growth rate for FY23 to 7.2 per cent. High inflation and interest rates will impact corporate earnings too.

It is important to appreciate the fact the situation is highly volatile. The big unknown factor now is how long the Ukraine war will linger since the war is the single most important factor that has pushed up energy and commodity prices. If the war suddenly ends it can trigger a crash in crude and other commodities leading to a moderation in inflation. Consequently, central banks may turn less hawkish than they are now. This will be positive for markets. But this is, presently, an unknown area.

Adopt a cautious investment strategy
It is better to adopt a cautious investment strategy in these highly volatile and uncertain times. Even after the recent corrections, the market is not cheap. At 16,000, Nifty is trading at above 18 times FY23 earnings. This is higher than the long-term average of around 16.

At the same time, valuations are fair and attractive in certain pockets. Therefore, investors can use the weakness in the market to slowly accumulate high-quality stocks in sectors like financials, IT and select autos.

In fact, calibrated buying in small quantities in blue chips across sectors would be a safe investment strategy. Mutual fund investors should continue their SIPs and, if possible, the amounts can be raised.

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