The future course of action on the stock market is likely to be determined by two key factors viz. crude prices and interest rates. We take a look at how both these factors could impact various sectors and in an inflationary environment, what could be investor's strategy?

The impact of high crude prices on the stock market is two-fold viz. on the economy side (inflation, government fiscal deficit and interest rates) and on corporates (raw material cost and lower demand for goods due to rise in prices of goods).

Though this is a complex topic, we have tried to simplify, some aspects may not be dealt with in detail.

On the economy side...

Firstly, almost 70% of India's requirement of crude oil is met from imports. Considering the fact that demand for crude has been steadily rising over the years, when prices are higher, the government has to pay more. There are two implications.

One, since the petroleum sector is highly subsidized, the government shares some part of higher cost of crude by keeping prices of petroleum products like diesel, petrol and LPG lower (this benefits consumers). Since this subsidy is a part of government's profit and loss account, expenditure increases.

If income does not rise proportionately, deficit (expenditure minus income) increases. So, the government has to borrow more to bridge the loss.

Secondly, when crude prices increase, as we mentioned earlier, the subsidy bill of the government goes up and more importantly, petroleum product prices have to increased to prevent oil companies from going into losses.

So, the government, in consultation with companies like BPCL and HPCL, hikes petrol and diesel prices. This has an inflationary effect directly (input cost for corporates and consumers goes up) and indirectly (transporters hike charges).

Since Central Banks across the world are concerned with inflation, they may increase interest rates to slowdown the economy.

On the corporate side...

Here is a snapshot of the impact of crude prices on some sectors.

Aluminium - Power cost could increase. But firm prices could provide some cushion in the near-term.

Automobiles - Higher diesel and petrol cost could slowdown demand. Rise in interest rates will impact demand, as most of the purchases are financed.

Banks - If RBI were to rise interest rates (which is likely to happen), retail credit (the key growth driver at the topline level for the last five years) could suffer. Housing and car loan disbursals, especially, could be affected.

Cement - Power and freight cost likely to increase and thus, could limit margin expansion even as prices are increasing.

Pure refineries - To benefit from higher margins, as prices are globally benchmarked.

Refining and marketing companies (like BPCL) - If retail prices are not increased, will have to share additional burden and profitability could suffer (as it did in FY04).

FMCG- As cost of daily needs increase, topline growth could suffer.

Engineering - Economic slowdown could result in order book growing at a slower rate.

Power - Plants those are dependent on crude products as a source of power generation could be hit.

Which sector to be in? - Considering the possibility of interest rates heading north, we suggest investors to be cautious when it comes to high capital-intensive sectors like commodities (refineries, steel, aluminium, power and so on).

Any company with high debt-equity ratio should be viewed with caution. Though most of the corporates have already finalised their funding plan, one needs to exercise caution when it comes to mid-caps.

Sectors like software, pharma and capital goods sectors (will benefit from higher capital expenditure from corporates) could be less affected.

At the same time, we advise investors to exercise caution when it comes to valuations, as some stocks are expensive in these sectors as well. Invest in a staggered manner or if one does not have to expertise, a conservative mutual fund is a better option in uncertain times.

How could investors allocate their assets?

If interest rates are likely to move up: Among various asset classes the allocation is likely to be more skewed towards property (borrowing a loan and locking it at a lower rate), equities and short term fixed deposits. The allocation towards long-term debt mutual funds should be lowered.

Though a rising interest rate scenario is not completely favorable for equities, the decision to invest in equities or other instrument is purely a matter or risk profile and the relative attractiveness. Gold is also a good option in an inflationary environment. Compared to what a fixed deposit and debt mutual fund, the case for equities even now is very strong.