Kal Mai Girega: Who Supports the Support System (2/5)

We had started our first piece in a series of 5 yesterday, discussing the key catalysts that could trigger the next bear market. The markets shed north of 800 points yesterday - almost as if it were waiting for our series!

While perfect market timing is a skill mortals do not possess, what we can attempt to do is take a stab at when markets are looking relatively cheap or relatively expensive, and manage our asset allocation during these times. This series is just an attempt in improving reader understanding in that direction and we hope our reader take it as such.

If you haven't read part 1 of our series yet, now would be a good time to go through it: Part 1- Catalysts

And I will try to fix you

When COVID first began to make its presence felt, the central banks and governments both jumped in, trying to do their best to support the people and the economy. While the Fed's support has been most popular in media circles, a fair bit was done back home as well.

The RBI dived into its rescue mode, slashing rates and providing other monetary policy measures in order to improve rate transmission. Our repo rate for example has dropped 115bps over the last year with major drops in March and May of this year. If that weren't enough, it conducted multiple Operation Twists in an attempt to bring down long term interest rates.

The government to its credit also attempted to provide support to those most affected - small and medium businesses, farmers and agri workers, displaced migrant workers. Providing the basic necessities to our poorest was the need of the hour, especially in a time when millions with little to no savings lost their livelihoods though no fault of their own - and while there was a lot lacking in the governments stimulus package, atleast on the basics it checked most boxes.

The markets understandably reacted favourably to the support. Sure we were in a tough spot, but support was always available - and the powers to be were backing their words with action.

But who supports the support system

But the support systems have limitations too, and in recent times, they have started to become more apparent.

The reserve bank for example has the task of managing inflation - a critical challenge given the direct impact on the purchasing power and thus well being. While the Fed has managed to take a rather loose stance on the issue, further strengthened by the flexibility on the inflation levels, this is not a privilege the RBI has. We discussed the problem the RBI is facing with inflation in a detailed post here and a detailed take on the perils of stagflation here. With inflation spiralling upwards, the RBI may increasingly find its hands tied - translating to a break in any further rate cuts.

The government too finds itself in a tricky spot, will the needs to pull the country out of the quandary rising, and its sources of income (aka taxation) plummeting. While our GDP growth as anything but impressive leading into the pandemic, it has dropped more than 23% in Q1! So bad is the state of the government coffers, that the Finance minister had to fall back on calling the pandemic an act of God to justify the center's inability to make good the GST shortfall.

The government and the central bank are the support system for the economy and the market in the time of crisis - but it increasingly feels like one of those has its hands tied by the inflation objective, and the other by a deep deficit..

More importantly, while the RBI could be expected to get its mojo back on the back of a drop in prices after the bumper kharif season and unclogging of the supply networks, the problem the government faces seems to be a circular one - and something it could need quite some time to get out of.

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