Will inflation stand in the way of the stock market delivering stellar returns this

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year? There are concerns over macro variables, such as inflation and over monetary and fiscal policy. Headline wholesale price index (WPI) inflation has shot up to 7.3 per cent for December, surpassing the Reserve Bank of India’s financial year-end target of containing it at 6.5 per cent. The November consumer price index (CPI) was up 13.5 per cent on a year-on-year basis. The Sensex has been trading in a broad range of 17,000-17,800 for the past two months.

Rising inflation does not per se mean weak equity markets. It could also be viewed as an indication of srong growth momentum in an economy, which is likely to help companies give better returns. According to CLSA Research, during the four cycles in the decade (2000-2009) when inflation rose considerably, Sensex continued to return 16-17 per cent as growth was robust.

However, in the two instances when the economy was faced with supply-side inflation, the market lost 17-22 per cent during the period. “While there is no clear trend across sectors, it does appear that consumer staple stocks underperform during periods of demand-pull inflation, despite the perceived high pricing power of the underlying companies," said Neelakantan Krishnan, head of research at CLSA India, in an internal client note. Krishnan said that an analysis of the previous bouts of inflation showed that the markets could endure inflation during a recovery stage.

One thing is clear: Rising inflation is a short-term overhang on markets. "Banks have underperformed during episodes of high inflation (when the WPI exceeds 8 per cent, which we think is round the corner). We would recommend that investors tactically tilt their portfolios toward defensive and non-rate sensitive sectors in the shorter term as the overhang of inflation and RBI policy action abates," said Prabhat Awasthi of Nomura Financial Advisory and Securities (India).

A correction of about 10 per cent would offer a better entry point into rate cyclicals, he added.

While many believe that the RBI may take action to curb inflation soon enough, it is the timing of the decision that is causing jitters in the market.

"High inflation in India can force policymakers to raise interest rates too much too soon. We believe that inflation in India is supply side-driven and is not likely to be contained by raising interest rates. However, to keep inflation expectations in check, policymakers may resort to interest rate hikes and that may have a short-term impact on the markets," said Ramanathan K, chief investment officer (single manager investments) at ING Investment Management India.

According to Krishnan of CLSA, the highest risk of a quick reversal in earnings momentum is for the auto sector, as the combination of monetary policy tightening and withdrawal of financial stimulus poses a risk to FY11 passenger vehicle demand. Consumer stocks could also see their earnings impacted by rising input costs.