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The Dawn is still Sometime Away

The common sense view is to hold the current proportion and continue investing systematically

During the past three years, the RBI has consistently followed a policy of raising interest rates in the hopes of combating inflation. At the same time, policy makers have taken little or no action to sort out all the obvious bottlenecks that keep the Indian economy underperforming. To add to our woes, the global economy has gone into a “double dip recession”.

As a result of the prevailing economic conditions – slower growth and persistent inflation – investors have received little in the way of returns from any major asset class in the past couple of years. Equity values have gone nowhere really. The Nifty is trading roughly 15 per cent off its peak of 6,200-plus, despite undergoing a minor recovery in the past six months.

The other major asset class, debt, has done badly as well. Debt funds have negative returns in general, as one would expect in a regime of rising rates. The interest yield from fixed deposits have been high in nominal terms but not high enough to be positive after adjusting for inflation.

Among other assets, real estate values have more or less stagnated. The real estate sector is among the hardest hit segments of the economy. Precious metals have been among the few exciting performers but there are real risks now in buying gold or silver since they are close to historic highs.

Overall, the effect on portfolios has been pretty disastrous. Experienced investors can accept short, sharp bear markets because they know that prices will recover and they can reduce cost of acquisition by accumulating at lower prices. But even the most rational and committed of investors gets tired of accepting losses over a long period of time. There is a temptation to starts restructuring asset weights in the hopes ot finding a better mix. That can make things even worse since it implies selling equity at low prices.

The mutual fund industry has given very poor returns over this long period. The industry can scarcely be blamed for its poor performance. Fund managers aren’t magicians who can conjure up positive returns when most assets have negative yields. Most active funds have underperformed their benchmarks in the past two years. This is true globally.

The investors too have moved away from mutual funds as a result of two years of poor results. The RBI data on household savings shows that retail allocations for mutual funds has been negative in the past few months. That is, there have been net fund redemptions – over Rs 20,000 crore – that has been pulled out in the past year or so. Investments in direct equity are also low, though are on the positive side. Investments in other financial assets like bank fixed deposits and ULIP insurance schemes have done much better due to inflows from households.

Think about what this tells us about retail investor psychology. If an investor prefers to buy equity directly, instead of via mutual funds, perhaps he is trusting himself to beat the market or at the least, to beat fund managers. Or more likely, the Indian retail equity investor doesn’t invest in mutuals anyway and vice-versa, mutual fund investors don’t invest directly in equity.

When we look at debt, we see an interesting example of risk-aversion. Debt is a guaranteed loser when you account for inflation but it does preserve principal. A very high reliance on debt during a period of rising rates indicates that there is an extreme lack of confidence in growth and hence, a fear of equity.

A preference for investing via Ulips rather than mutual funds also suggests that the fund industry has simply failed to educate investors about the respective pros and cons of these instruments. In India, the much higher Ulip commissions vis-a-vis mutual funds leads to a skew in distributions as well. Also, few investors are evolved enough to understand why combining insurance and equity is a bad idea and it is at least partially the fund industry’s fault that it hasn’t got this message across.

The current economic situation makes it very difficult to offer advice to investors as well. The Indian economy (global economy too) is in a mess. Indian government’s finances are stretched with a massive fiscal deficit and a record trade deficit. Inflation is still pretty high despite high interest rates, lower demand and slow growth. Given the current inflation numbers, the RBI might not raise rates but it probably won’t cut either for several months, maybe not until end-2012. This implies that there may not be much improvement in economic fundamentals and there may in fact, be further deterioration.

So let’s consider asset allocations against this backdrop of gloom and doom. First, it may be well to make a small comment on real estate since that is usually the largest share of household assets. The overwhelming majority of home-owners will a) pay a cash component off the books; b) take out a mortgage on the official price. The relatively soft real estate market creates a potential opportunity since prices have dropped in terms of both cash and cheque components.

However, housing loan rates are pretty high and that means raised EMIs. Against that, a floater taken at current rates may become cheaper if rates fall through the next two or three years. The other worrying factor is that a lot of real estate projects have stalled due to builders being starved of capital. So, any buyer of either residential or commercial property would have to undertake careful due diligence.

Debt is definitely worth holding now assuming the cycle of rate hikes has topped out. It is also worth taking new positions in debt funds with portfolios that have a medium- to long-term tenure. As and when the RBI does start cutting rates, there will be serious capital gains available from this segment. So there is quite a good case for increasing allocations in debt funds.

The commodities space presents interesting questions. First, there are practical difficulties holding a commodity component for an individual who is not a professional investor and many won’t bother. But the advantage with commodities is that they are often un-correlated from other financial assets. Hence, they can provide good hedges and a commodity component is recommended in a financial portfolio if the investor has the ability to manage it.

Non-precious metals and other industrial inputs will probably be weak through the next year or so, due to slow global growth. Energy prices should also be down-trending under normal circumstances for the same reasons. But the ongoing Middle East civil wars and the US attempt to sanction Iran together present serious risks of supply disruptions and that could force crude and gas prices up.

Given a poor monsoon, agro-commodities could flare up in price and there may be opportunities here. But the government is almost guaranteed to take hamfisted measures to stop futures trading if items in the food basket do trade high.

Precious metals are high-priced at the moment. This is about the only asset class that has done well over the past two years. Despite the high prices, gold and silver could certainly trend higher if the euro collapses. But gold will slip sharply lower if the currency stabilises and the instant the global economy starts growing quickly again, there will be a price correction in precious metals.

Platinum could be an interesting play. There’s likely to be supply disruption issues because South Africa, which has 80 per cent of global reserves, is in the middle of a major mining union dispute. If the trouble continues, a long futures position in platinum could really pay off big.

Allocation to equities is a really difficult question. Incidentally, the recent Sebi rulings about mutual funds and expense ratios should induce investors to invest directly with the AMCs rather than use distribution channels. But it doesn’t really affect the basic question: should the investor increase or decrease or maintain the current proportion of equity.

There is no light at the end of the tunnel yet. The short- to medium-term trends suggest that earnings and turnover growth will be very slow or negative for a while. The bearish perspective would be fine if equity prices had moved down to reflect the situation – then there would be a case of value-based buying. However, the market has continued to trade at current PEs of 17-plus, which is a much higher valuation than any projection or estimate suggests is viable.

The common sense view would be to hold the current proportion and continue investing systematically. Wait for a correction in the stock market before increasing allocations to equity. Also, there’s no point in trying to be selective. The downturn has pretty much affected every sector and an upswing will probably lead to improved prospects for every sector. Given the statistics on actively-managed funds, it is far better to go with ETFs or index funds, rather than try to beat benchmarks.