The signals from the bond market, the global commodity markets, and policy makers are all extremely negative. Interest rates are likely to trend further up for a while. How much further up and for how much longer are open-ended questions.
Let’s run through some of the signals. The RBI expressed concern about the fiscal position in its last review. The latest inflation and IIP numbers show that inflation is still at uncomfortable levels and (unavoidable) fuel price hikes have added to upward pressures. The SBI took out massive provisioning against NPAs in Q4, 2010-11 and Pranab Babu also expressed concerns about NPAs.
Crude rules at roughly $120/barrel and there is no end to the turmoil in the Middle-East & North Africa. Hence, concerns about oil supply disruptions will not ease off. Every player in the financial markets is now expecting another hike in rates and so are most consumers.
What can be done
There isn’t much to be done about the root causes of inflation. Commodities (fuels and metals in particular) follow global trends. In the past 12 months, there has been a huge global surge in prices. Rise in metal prices has been driven by resurgent global demand. The fuel surge is partially driven by global GDP recovery and also by political turmoil in prime crude and natural gas production regions. In addition to this, India has food inflation.
Demand for metals would slow if the world economy cools off. There are some signals in that direction. Unfortunately, between global inflation and recession, the former is probably the lesser evil. India’s exports (goods and services) have grown rapidly through the past 12-18 months and helped offset a rising import bill to some extent. In recession, exports will be hit hard while imports cannot drop that much due to the energy-deficient nature of India’s economy.
Food inflation can only fall in the short-term if there’s a good monsoon. In the long-term, hard decisions are required to free agro markets, induce larger investments in irrigation, water-management, cold storage and food-processing, and to build better rural infrastructure (roads to get produce to market; power to store food until it can be consumed).
Fuel prices are utterly out of the government’s control. India is a price taker in the global markets. If the government imposes retail price controls while being forced to import at higher prices, it accepts a bigger fiscal deficit while gutting the balance sheets of energy sector PSUs.
If the government decontrols fuel prices now, generalised inflation will jump. This would be politically unacceptable and probably lead to unrest. If it had possessed the nerves, the government would have decontrolled in 2009 when fuel prices were 66 per cent lower. That would have given the economy, and society at large, two fiscals of lower fuel prices and experience at handling market pricing. Price decontrol now is extremely unlikely, unless things get a lot worse.
Given the above, an investor will have to live with a rising rate cycle, inflation, and distorted government finances. Higher interest rates mean lower equity prices — this inverse relationship is well established. Higher rates also mean negative debt market returns.
Another problem: when consumers expect inflation, they cut back on discretionary spending. This hits growth. So, what should an investor do to handle a doom and gloom scenario of this nature? He must find answers to the following questions:
Do you need to review asset allocation?
The answer depends on your assessment of how long you think this situation of falling equity prices and rising interest rates will last. If you think this will blow over in a reasonable time frame — 12 months or even 24 — you shouldn’t change your asset weightage.
If you think that this situation will last for years, you do need to review weightages. In that case, it makes sense to look at alternative assets like precious metals, gems, commodities, and artworks. These can be counter-cyclical and can give positive returns uncorrelated to financial markets.
Otherwise, stick to your current allocations. My instinct would be to leave allocations alone for the moment. One practical problem is that many counter-cyclicals are available only in opaque, imperfect markets and require specialised knowledge to trade in.
What defensive measures can you take?
Pure capital protection is a mug’s game in a highly inflationary scenario. That’s the problem with the traditional haven of Fixed Deposits. If your FDs consistently fetch less than inflation, it doesn’t matter if the face value of your savings is maintained; your buying power disappears.
If you can find counter-cyclical assets and you have the skills to trade them, best of luck. Otherwise, you have to rely on cyclicality eventually acting in your favour. Sometime or the other, the economy (global as well as Indian) will adjust to the current problems and start a recovery. Once it does, the value of non-cash portfolios will rise. This is the major argument in favour of continuing to create passive, broad-based systematic exposure to equity and debt.
Are you prepared to hedge?
If you think the stock market will be priced lower and the bond market will have higher yields, or the rupee will lose ground some three or six months down the line, you can hedge against these.
The derivatives market offers highly liquid index options on the Nifty. A long put with a December 2011 expiry and a strike of 5,000, which is 10 per cent below the current prevailing index levels, costs Rs175, about 3.5 per cent. Such hedges could offer highly leveraged multiple payoffs. Similarly, rupee denominated forex futures and options are available with distant expiry.
How do you average down?
If you assume that prices will trend down, and you want passive systematic exposure, you should try “weighted” averaging down. In other words, you should invest more when prices fall more. If you increase equity allocations by, say, 10 per cent for every 10 per cent fall in the Nifty, your cost of acquisition will drop faster than if you did an EMI-styled SIP.
Since you don’t know where the market will bottom you have to set what you consider acceptable valuation levels and take steps for carrying out a weighted SIP.
My personal rule of thumb: The market usually touches a new all-time high, every four or five years. This means it should surpass the minimum target of Nifty 6,350 (the all-time high of 6,357 came in January 2008) by 2013. Hence, if you buy at current (5,500 Nifty) levels you can hope for a return of 15-20 per cent by 2013. That’s acceptable but not great. However, if the market falls to 5,000, the return on a bounce to 6,350-plus rises to 25-30 per cent. That’s pretty attractive.
So, I would be willing to increase equity exposure significantly at Nifty 5,000 level or lower, by implementing some sort of a weighted average SIP. I would also look at short-term deposits in money market funds — that’s one of the few debt instruments that retains value in a rising rate regime. Maybe you can park surplus funds in short-term deposits, rolling those funds over until such time as the Nifty hits 5,000 or lower and then move more money into the stock market.