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Inflation – Can’t igore it anymore

Posted by fairval on February 3, 2010

Inflation vs ROE

When even a consulting firm starts talking inflation, you know a big issue is at hand.  The chart above is from a recent Mckinsey note. It makes an interesting point, which investors often miss.

In inflationay times, companies will often tell analysts – we will be able to pass on costs, so there is no reason to worry about inflation. Mckinsey points out – maintaining reported net profits is not enough.  You need to maintain cash flow stream, and that will likely mean that RoE needs to go up. Or roughly speaking, the gap between inflation and RoE needs to be maintained.

So ask yourself this question – Inflation has shot up by say 1000 basis points,  or 10% points in India (never mind official WPI data). So have corporate RoE’s gone up by the same amount?

This almost never happens, as Mckinsey’s chart for US points out. Corporate RoE’s dont swing by that much, and certainly not at times of high inflation. No amount of belt tightening can generate that response for entire listed corporate sector. So atleast some, or quite a few companies will suffer. The US markets were flat for much of the decade of ’70s and early ’80s when inflation was high.

A note from Nomura points out how Indian markets have Indian markets tend to fall sharply whenever WPI has crossed 8% in the last decade.  It says – only a matter of time, and ‘when’ not ‘if’ – the markets will react to inflation. They already are reacting, but atleast another 10-15% further down from here needed as a decent response to high inflation.

Inflation versus Market Performance - India (source- Nomura)

 Anyway, a correction is welcome. Valuations are too high for most companies.

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One Response to “Inflation – Can’t igore it anymore”

  1. Munish Hingorani said

    Markets correct based on inflation expectations – before inflation shows-up. But inflation is already 8% (or 10%?).

    It could be that the markets expect a double-dip in the developed economies. That should keep supply-side inflation under check and liquidity immense.

    Comparisons with past data may not be correct. We are in the age of the new normal.

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