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Dealing with Turbulence

The economy has hit a sour spot. Here's how you can protect your portfolio from being severely pounded

What should you do when no asset-class appears attractive? First, acknowledge that the economy has hit what can be called a “sour spot” as opposed to a sweet spot. It happens at some point in every cycle when inflation impacts growth, valuations and sentiment. Such negative scenarios can last quite long.

Take a very broad look at current events. Projections suggest that Indian GDP growth will remain strong through 2011-12, as well as in the last quarter of 2010-11. That’s the good news. The bad news is that interest rates and inflation have risen through the past 12 months and will surely rise further.

The second factor outweighs the first when it comes to investment returns. There is a negative impact across almost every asset class when interest rates go north. Debt becomes less attractive. Equity becomes less attractive. Real estate goes soft. Business profits are hit by rising interest costs. Currency can come under pressure.

Hedges against inflation
Some counter-cyclical hedges can gain but they must be picked with care. For example, gold and other precious metals are a traditional hedge against inflation. But gold is currently at record highs. That makes it a risky investment. The chances of capital loss in the yellow metal are quite high.
Another set of potential counter-cyclicals are crude, gas, coal and other energy commodities. Energy costs are major contributors to inflation; if energy cost rises, everything else costs more. Unfortunately, India’s energy sector is distorted by arbitrary, illogical policy creating big risks.
A third counter-cyclical sector is agro-commodities — sugar, tea, coffee, oils, etc. Price movements in such goods are influenced by specific supply-demand issues and may be out of step with the overall economy. But many of these commodities are hit by random policy distortions as well.

What should you do?
So what should a rational investor do? Try and assess how long the current scenario could last, where inflation might peak, and what could be the downside for equity values. The answers here aren’t encouraging. We appear to be in the initial stages of a sour spot.
In Indian history, inflation has always peaked well above double-digits and stayed above double-digits for long periods — at least six months, or more. The Indian economy hasn’t changed that much structurally. Market interest rates should peak at 13 per cent plus and stay up for at least two or three quarters. Indian bear markets also tend to correct 30-50 per cent from the peak values of the previous bull market.
The implications are that rupee interest rates may rise to one-and-a-half times current levels. The Nifty is already down 11 per cent from its November 2010 peak. But it could drop another 1,000 points or more before it bottoms. In terms of time, we may see this situation continue into late 2011-12 or even early 2012-13.
This is not a worst-case scenario — it’s median. Obviously in a best-case scenario, inflation will be tamed at much lower levels and the equity correction won’t go that deep. But the current negative pressures are due to factors over which the government of India has little, if any, control. Crude is expensive; food is expensive; what can the government do about it? Not much.
If we’re in the initial stages of a longish journey south, the active investor should seek to preserve capital until he sees some signs of bottoming. One possibility is to rollover short-term fixed deposits of say, 14-21 days. Any fixed-income instrument will suffer opportunity loss if rates are being hiked. But the losses are less at the short end of the scale.
Despite policy risks, I would look seriously at agro and energy counter-cyclical possibilities. Apart from commodity futures, sugar, for instance, has listed plays. So do tea and coffee. India’s natural gas demand-supply situation is changing from deficit to adequate. A vast amount of investment is going into every link in the value chain — from exploration and exploration logistics support, to city distribution, to pipelines. Renewables also respond positively to high crude prices. There could be a revival in the wind power industry and new plays in solar.
The above switch to active selective investment sounds like heresy, given the generally strong case for passive diversified equity exposure. But there’s no sense in sailing straight into a storm that is already visible.
An SIP-based index investment strategy through 2011 will not do badly in the context of three years. But it may deliver negative returns over 18-24 months. The short-term deposits I suggested? I would bring them back into index-based SIPs if the Nifty falls below 5,000 and/or if global crude prices drop below $75 per barrel.