Markets won't skid on oil and inflation

11 May, 2008, 0447 hrs IST,Shubha Ganesh, TNN

The stock markets had a good 15 percent rally over the last few weeks. The Nifty has been consolidating for the last couple of days around the 5,100 levels, but was not very convincing. The global markets have been edgy and the economic indicators in the form of inflation and prices of crude oil were not very positive. In this backdrop, investors questioned the market's ability to continue its upward journey.

Oil prices head northwards

The latest surge in oil prices has sparked worries over inflation and the impact of higher energy costs on corporate results. Oil prices hit a record high of $124 a barrel on worries of supply disruptions. There were concerns about supply disruptions in Nigeria where oil production was stopped.

The surge in oil prices to an extent could be attributed to the decline of the dollar. The dollar's continued decline against the euro and other foreign currencies since last year had investors looking around for a hedge against inflation. Oil seemed a good one and thus saw a step rise in the last few months.

Usually, when the dollar strengthens, the effect usually reverses, sending oil prices lower. However, this trend did not continue after the dollar strengthened in the last few days and oil prices continued to move upwards. The upward momentum just seemed to continue regardless of all negative news.

The decline in demand for oil, which normally accompanies a sharp increase in price, was not evident giving further fuel to this enormous rally. Curiously, the stock markets have absorbed the oil price increase quiet smoothly and consolidated instead of falling.

Surging oil price and markets

The surging oil price is indeed a dangerous situation for the markets. As far as the economy is concerned, it has severe implications. A fund house has calculated that when crude is at USD 110 per barrel, the gross under recovery in oil is of about Rs 1,75,000 crores which is about one lakh crore more than their total under recovery for the fiscal 2008. As the crude prices head higher the under recoveries are bound to increase.

There is a lack of clarity from the government as to how this money is going to be recovered. The government may give more oil bonds and recover some portion from the upstream companies.

But oil bonds will just push the government's cost of borrowings. As elections are near, the government's willingness to increase the price of crude at retail level will be low. Hence, we have a situation of oil prices remaining stable at retail levels with the government and oil companies absorbing all the losses, putting their balance sheets under enormous pressure.

Volatility in the short term

Currently, most analysts do not expect a major rally in the stock markets, mainly due to increase in global commodity prices and its impact on inflation. However, there is a change in the FII perception of India. Many of them had been underweight on India for a long time but the markets proved them wrong.

Hence, they now feel India is a good long-term buy, though in the short-term they see some weakness. Most fund managers feel that in the shortterm we could have a rangebound market with volatility because the volumes are very low and any spike in volumes is contributing to volatility.

All institutional investors are waiting for a decisive turn in the strength of the dollar. For a strong dollar will depress commodity prices and inflation. They believe the long-term growth story is intact and want to invest aggressively in India as the valuations become more realistic.

In this scenario, investors may find it is best to wait and watch before investing in the markets for the short-term . However, for a long-term investor it is best to stay invested because on a oneyear horizon markets are expected to recapture old highs.

via:E.T