The RBI raises risk to the market ::Nomura

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STRATEGY QUICK COMMENT
The RBI took the market by surprise today and hiked the policy repo rate by 50 bps vs. market expectations of 25
bps. Further rate hikes would depend on the inflation trajectory, which in turn would depend on the trajectory of
domestic growth, global commodity prices and performance of the monsoon. From a market perspective, we remain
positive on a 12-month horizon and would be buyers on dips. Our portfolio stance reflects risks to growth by staying
away from sectors which could underperform amidst potential growth concerns – i.e. autos and cement.


The RBI raises risk to the market
The RBI took the market by surprise today and hiked the policy repo rate by 50 bps vs. market expectations of 25 bps. Further
rate hikes would depend on the inflation trajectory, which in turn would depend on the trajectory of domestic growth, global
commodity prices and performance of the monsoon.
We make the following two observations:
1. Tricky transmission lags: The RBI appeared to not be overly concerned about the slowdown in growth following the
cumulative impact of rate hikes since Mar-10. While growth was beginning to moderate, it found little evidence of a sharp
broad-based slowdown. Invoking Milton Friedman’s “Fool in the shower”—calibrating water temperature in a shower can be
tricky, much like the uncertainty of transmission lags in monetary policy; turn on the temperature knob too high in response to
cold water and you risk scalding yourself—we think that an overly hawkish stance on inflation could take a greater toll on
growth than the RBI is assuming at the moment. We said in our 27 June strategy note (“A glass half full; 27 June 2011) that a
slowdown in growth is not necessarily a bad thing in a supply-constrained economy, characterised by a steep aggregate
supply curve, such as India’s when it happens following a deliberate and concerted attempt by the central bank. Evidence of a
slowdown has already spread from the investment cycle to the consumer. How deep it gets remains to be seen in the coming
months.
That said, we think market valuations are accounting for these risks to an extent. Our portfolio stance reflects these risks by
staying away from sectors which could underperform amidst potential growth risks – i.e. autos and cement.
2. Inflation risks: Inflation remains the predominant macro concern for the RBI at the moment and further rate action is
dependent on the evolution of the inflation trajectory. The RBI most likely looks at headline inflation numbers which we think
would likely remain elevated in the coming few months as the full impact of the recent rise in global commodity prices gets
incorporated fully. A hawkish anti-inflationary stance by the RBI combined with the ongoing slowdown would serve well to rein
in inflationary expectations even as the headline inflation print concurrently remains elevated. The resulting rise in ex-ante real
interest rates would tighten the screws on the economy further.
An analysis of deseasonalised inflation numbers suggests that inflation momentum has already peaked (in Apr-May of this

year, we estimate). Upside risks to inflation could come from three sources: 1) subpar monsoons - seasonal rainfall until 20
July remains 1% below long-term average and the spatial distribution of rainfall too looks satisfactory at this point, 2) a further
significant rise in global commodity prices from here – we note here that even as a weak global growth scenario would likely
keep global commodity prices in check, there is a significant favourable base effect that would come into play in year-on-year
comparisons (the relevant metric for inflation) in the coming months after global commodity prices surged starting Sep-10, and
3) softening demand – a further moderation in aggregate demand on account of rate hikes so far would ease demand
pressure and lower inflation expectations in the coming months.
We have reminded investors repeatedly in the past that market momentum typically reacts contemporaneously to a steep rise
in inflation, and not to rates. Today’s action in equity and rates markets following RBI’s hawkish stance suggests to us that the
market would likely be extra sensitive to inflation readings in the coming months. To this extent, we think the markets are at
risk for the next 2-3 months. We judge the potential worst-case downside scenario to be 8-10% from here. We would start
buying aggressively at levels 5% down from here.