What should MF investors do in the high inflation, high interest rate environment?

India’s retail inflation (CPI) had surged to an 18 month record high in April 2022. While inflation over the past 12 months has been well above RBI’s long term target of 4.5%, CPI inflation spiked up further after Russia’s invasion of Ukraine. India is not alone, as far as high inflation is concerned; high inflation is a global phenomenon. Central banks around the world are working on war footing to control inflation and their actions will have impacts on financial markets.

Why is inflation bad?

While moderate inflation is considered to be good for business, high inflation is bad for the economy. The poorest sections of the populations with limited income are hit hardest by high prices. High inflation is also not good for most industry sectors because consumers may reduce their demand when prices are high. High inflation is also not good for investors. Central banks e.g. RBI will raise interest rates and try to reduce money supply to control inflation; higher interest rates and lower liquidity will have a negative impact on financial markets.

Relationship between inflation and interest rates

There are two causes of inflation – demand pull and cost push inflation. The current inflation situation is a result of both the factors. Demand pull inflation is a result of greater demand for goods and services by consumers. The fiscal / monetary stimulus provided by Governments during COVID-19 and reopening of the economy, travel etc.has resulted in demand pull inflation.

There are supply side factors, e.g. supply chain constraints due to restrictions on movements, lockdowns etc. during the pandemic, War in Ukraine and sanctions on Russia etc. have resulted in shortage of supplies, resulting in cost push inflation. One of the most important monetary policy tools to fight inflation is interest rate hikes. If the central bank e.g. RBI hikes interest rates, money supply will go down since people will not be ready to borrow money at high interest rates. Lower money supply in the economy will result in lower inflation.

You may also like to read what should long term investors do when there is a war?

The US Federal Reserve has already hiked interest rates by 75 bps in 2022, while the RBI has hiked interest rates by 40 bps in May 2022. While monetary policy (rate hikes) are effective in controlling demand pull inflation, it may take longer to have an impact on cost push inflation unless supply side issues are also addressed.

Impact high inflation, high interest rates on asset classes

• Equity: As mentioned before, high inflation may lead to reduction in demand for goods and services. This may result in lower revenues and earnings for companies. If interest rates are high, companies may hold back on expansion and capex plans because of high borrowing costs. This will have an impact on their earnings growth outlook and share prices. Finally if the US interest rates / bond yields are high, then Foreign Institutional Investors (FIIs) are likely to find US Treasury bonds to be more attractive investments from a risk perspective. A related factor is currency depreciation due to high inflation (commodity prices). Generally, high inflation leads to currency depreciation. Currency depreciation will make Indian equities less attractive relative to investments in the US, causing FII outflows; this may result in a vicious cycle as FII outflows leads to further currency depreciation. The overall impact of high inflation and interest rates on equities is negative.


• Fixed income: Price of debt or money market instruments go down with rise in interest rates and vice versa. Interest rate sensitivity of debt funds increase with duration; longer duration debt funds will be impacted more by inflation and increase in interest rates. In a rising interest rate scenario shorter duration debt and money market instruments become more attractive because the maturity proceeds of these instruments can be re-invested in instruments giving higher yields.


• Gold: Gold prices usually rise with inflation. However, interest rates also have an impact on Gold prices in international markets. Gold is already near its historical high, and in a rising interest rate scenario, international investors may find US Government Bonds to be more attractive than Gold. However, as far as India is concerned, domestic price of Gold is linked with our currency movement. As the India Rupee (INR) depreciates, gold will appreciate (generally high inflation results in currency devaluation). Gold price in INR is already up by 6% on a year to date (YTD) basis (as on 26^th May 2022).

How to invest in the high inflation, high interest rate environment?

• Asset Allocation: High inflation and expected trajectory of interest rates have caused volatility in financial markets over the past few months. The Nifty is down 7% on YTD basis (as on 26^th May 2022), while the broader market has seen deeper cuts with the Nifty Midcap 150 index down by 12% on an YTD basis (as on 26^th May 2022). Asset allocation is spreading your investments over different asset classes e.g. equity, fixed income, gold. Asset allocation is important in volatile markets, since it reduces volatility in your portfolio.
  
  Your asset allocation will depend on your financial goals and risk appetite. You should consult with your financial advisor if you need help in deciding your asset allocation. Equity, fixed income and gold outperform each other in certain market conditions and vice versa (e.g. equity outperforms gold in bull markets and under-perform in bear markets). Asset allocation will bring stability to your portfolio.
  
  Along with the traditional asset classes e.g. equity, fixed income and gold, you may also consider adding international funds. There is low or even negative correlation between returns of the different countries. International funds will add further diversification to your portfolio and provide stability.


• Equity: Though equity may underperform in high inflationary environment, it can beat inflation in the long term. Nifty 50 TRI gave 14% CAGR returns in the last 10 years ending 30^th April 2022 (source: National Stock Exchange, Advisorkhoj Research as on 29^th April 2022). Based on historical data we can say that, post tax CAGR return on equity investment (taking Nifty 50 TRI as a proxy for the asset class) over the last 10 years is significantly higher than the average inflation rate over the same period.
  
  As mentioned several times in our blog, you should always have long investment horizons for equity and also ensure that you have adequate diversification. As far as equity fund categories (market cap segments) are concerned, you should always invest according to your risk appetite. Historical data shows that, large cap funds are less volatile compared to midcap / small cap funds; you should make informed investment decisions based on your financial goals and risk appetite. You should continue your Systematic Investment Plans (SIPs) in equity mutual funds; SIPs can help you take advantage of market volatility through Rupee Cost Averaging (RCA).
  
  Since equities have corrected by significant percentage, some investors may want to take advantage of the correction by tactically investing in lump sum at market lows. You should understand that, it is always very difficult to time the market. You can use Systematic Transfer Plans (STP) from a low volatility fund e.g. liquid fund to equity fund and take advantage of market volatility through RCA. You should opt for a longer STP (6 – 9 months) since the rising interest rate cycle may unfold over the next several months. If you think that the market has bottomed before the end of your STP tenure, you can always switch the balance units from liquid fund to equity fund.
  
  Suggested reading: How can an investor know whether the markets have bottomed out?


• Fixed Income: You should have a flexible approach to fixed income in a rising interest rate scenario. As mentioned before, longer duration funds are likely to underperform relative to shorter duration funds, when interest rates are rising. Investors can take advantage of rising yields by investing in accrual based shorter duration funds that roll over their investments at higher yields, helping investors to get relatively higher returns and keep up with short-term inflation.
  
  As mentioned several times in our blog, credit risk should be an important consideration in fixed income investments. In a rising interest environment, credit spreads will widen and credit risk funds may give higher yields (YTM) but they also will have higher credit risks. You should always invest according to your risk appetite and consult with your financial advisor if you need help. In a rising interest rate scenario, issuers (e.g. NBFCs) may find it difficult to refinance their maturing debt obligations or be forced to refinance at a much higher cost. In such an environment, new debt fund investors are advised to stick to higher credit quality.


• Gold: Gold is an important asset class in India because it has significant cultural importance in our country. While families prefer to invest mostly in physical Gold e.g. Gold jewelleries, Gold exchange traded funds (ETFs) or Gold fund of funds are much more cost efficient investment options. As mentioned before, Gold is likely to outperform in an inflationary environment in India. Gold ETFs are among the best performing ETFs on an YTD basis (as on 26^th May 2022).
  
  However, you must remember that Gold prices are already high and upside potential may be capped in the moderate term when equities recover. Therefore, you should always have very long investment horizons for Gold since they may underperform for a fairly long time in equity bull market. You should invest in Gold according to your asset allocation requirements, which should be based on your financial goals and risk appetite.

Summary

In this article, we discussed about inflation, interest rates and its potential impact on your investments. Reducing inflation is one of the most important priorities of central banks. It is difficult to predict how long this period of high inflation will last, but historically (except during stagflation of 70s) it has lasted for a few quarters only (source: Federal Reserve Public Data). You should be disciplined and have long investment horizons. As mentioned in this article, asset allocation is very important in these conditions. You should consult with your financial advisor, if you want to know what your asset allocation should be. Investment journey is not always smooth but you should never make knee jerk reactions; if you have a disciplined and systematic approach to investing, you will succeed in your financial goals.