Sample this. In the last one year, CRB Reuters US Spot All Commodities Index has risen by an unprecedented 31.4%. Brent Crude has risen by 50.6%, while cotton prices almost doubled during the same period. The culprit was the Quantitative Easing - Round 2 (QE2) money being splashed across the global markets. When stock markets ran ahead of fundamentals, investors looking for alternate investments pumped this free money into commodity futures and ETFs.
The high commodity inflation which resulted ended up giving a headache to central banks in the emerging markets. To control the unbridled inflation, these banks started tightening their monetary policies. While the effect of this measure on inflation is questionable, what is obvious is that this policy stifled economic growth.
For Indian corporations, the high inflation and interest rates acted as a double edged sword. Higher commodity prices squeezed profitability while at the same time destroyed demand. Higher interest rates meant more expensive debt for companies as well as higher cost for consumers to finance purchases.
Recently, as QE2 drew to a close, the bubble built up in various assets classes including commodities started to deflate. In the last few months, commodities have started coming off their peaks with some commodities correcting by almost 20% in the last 3 months. While this shows that the global economy is slowing down, it is going to be a boost for India.
Cheaper commodities mean cheaper input costs and higher profits for corporates. It also means more disposable income in the hands of consumers. Moreover, lower inflation would be a signal for the RBI to take a look at reducing interest rates. In fact the government has also been eagerly waiting for inflation to decline. We believe that reduction of subsidies in fuel and fertilizers is long overdue and the government will grab this opportunity with both hands. On the slowdown in the global economy, we are not too worried. This is because we believe that the latent demand in India is sufficient to balance out any fall in exports due to sagging international demand.
While we don't expect the economic situation to turn around overnight, we see this development as the first signal for economic stability and a sustained rally going forward.