After lying low for many years, inflation is back in India. Last month, the consumer price inflation in India reached a seven-year high of 6.3 percent. The producer price index or wholesale price index is even higher and reached a decade high of 12.9 percent in May 2021.
In contrast, the interest rates on bank fixed deposits and post office deposits are in the range of 5 to 6 percent. As a result, the real interest rate – the headline interest rate minus inflation – is negative.
This has led to a search for an inflation hedge as most analysts expect inflation to remain high in the foreseeable future. The pandemic has disrupted the global supply chain of many commodities from computer chips and industrial metals to crude oil, putting upward pressure on prices.
At the same time, the global financial market is flushed with liquidity thanks to the record fiscal and monetary stimulus by major economies such as the United States, United Kingdom, European Union, Japan and China.
According to analysts, stimulus cash initially reflated financial assets prices such as equity and bonds from their post COVID19 lows but it is now fueling a rally in commodities including metals, crude oil and agriculture commodities. This in turn is leading to higher inflation all over the world.
Most analysts expect this trend to persist and even strengthen further if central banks including the Reserve Bank of India continue to insist on low interest rates. This makes it imperative for investors and savers to protect their portfolio from the corroding effect of inflation.
Currently, the most common asset class to provide a hedge against inflation is equity or stocks. In the last 10-years, the benchmark BSE Sensex has risen at a compounded annual rate of 10.8 per cent, far more than the consumer inflation during the period. This makes investment in equity mutual funds a good hedge against inflation.
The volatility rules out equity for retired people or those close to their retirement.
Investors should also remember the ‘superior’ returns in equity in the last decade coincided with low inflation and low interest rate globally. A combination of low commodity and energy prices and low interest rate expanded corporate margins and profitability that supported the rally in equities. This allowed top companies in many sectors to report strong earnings growth despite sub-par revenue growth.
There is no guarantee that this goldilocks combination may stay in future as inflation picks pace. This creates uncertainty over the future trajectory of equity markets.
Secondly, more than half of the returns in equity in the last ten years –at least in India — came from expansion in valuation rather than earnings growth. The expansion in valuation ratios such as price to earnings multiple itself happened on a low base in the 2011-2012 period. Currently, the valuation ratios are at an all-time high. For example, Sensex is currently trading at a P/E multiple of 33X, nearly double its P/E multiple of around 17X a decade ago.
While many bulls say that the valuation doesn’t matter anymore and stocks can get more expensive from here on if the financial condition remains benign, history suggests that higher valuation raises the downside risk.
Another way for investors to hedge against inflation is to invest in physical assets including gold and real estate.
To put it simply, it’s more expensive to build a house or produce a tonne of metal or gold today than 10 years ago due to the rise in energy and labour cost in the intermediate period.
In the last ten years, most physical assets have underperformed financial assets and there is a strong possibility of physical assets out-performing financial assets in the next few years if the inflation remains elevated for an extended period.
While real estate is a bulky asset and requires high investments, gold is a good inflation hedge for savers and investors with small amounts of capital.
While in the last ten years, gold prices have underperformed equities in India, the yellow metal has beaten the Sensex in the post-Lehman Crisis period in general. In the last 10 years, gold prices in India have risen at a compounded annual rate of 7.2 percent, which is higher than inflation but nearly 350 basis points lower than Sensex returns during the period. One basis point is one-hundredth of a percent.
However, despite the rally, the Sensex is up only two and half times from the pre-Lehman crisis peak of around 20,000 in December 2007 against four and half times jump in gold prices during the period. In other words, gold is a good way to hedge your portfolio when the risk of volatility in the equity market is either due to high valuation or potential macroeconomic risks.
Gold prices have been moving sideways for nearly six months now. Many analysts interpret this as price consolidation that could set the stage for the next leg of the rally in the yellow metal. This offers a good opportunity for investors to book some profits in equity or cut their exposure to bank FDs and invest that money in gold. This will help protect their wealth and purchasing power.
(Advice: This article is for information purpose only. Readers are advised to consult a certified financial advisor before making investment in any of the funds or securities mentioned above.)
(Karan Deo Sharma is a Mumbai-based finance and equity markets specialist).