Interest rates and the impact on your investment return
The world has witnessed massive swings since March 2020. We are nowhere close to economic normalcy. Let’s understand what is happening in the world and how does that impact your investment returns.
Any student of finance will appreciate that the current scenario is a textbook version of how the world should be dealing with slow growth and inflation. However, a new variable, supply chain disruption is added to this equation.
A central bank increases interest rates to reduce inflation in the economy. Similarly, central banks reduce interest rates to provide growth stimulus. To maintain growth, developed countries reduced interest rates to their historical lows in 2020. Additionally, provided free money to everyone so that growth momentum doesn’t break.
When interest rates drop, investors pursue risky asset classes. In 2021, every day we heard unicorns being created. There was no change to cash flows (still negative) but suddenly the founders and a lot of employees with ESOPs became wealthy. Most of these people thought they are so skilful, but a lot was happening just because the wealthy lot of the world started allocating in these asset classes (private equity/VC).
In late 2021, the music stopped. Inflation started mounting and the central bank started to increase interest rates. Suddenly, investors started to look at asset classes that were not risky. Startups relying on external funding started running out of cash leading to problems for banks providing these startups credit (SVB etc.).
As the world was tackling the situation of rising inflation, Russia and Ukraine war broke out. As we all know, Russia is a leading oil and gas producer in the world. It was obvious that the oil and gas supply will get disrupted leading to higher prices. So much so countries like Germany went back to burning coal to keep industrial production going.
Although the Covid health crisis is history now, a lot of economic issues planted due to Covid are still going on. USA, UK and others are still dealing with high inflation, the central banks are still increasing interest rates. These countries are already at a high-interest rate level, if this continues, they may be looking at flattish growth for a few years.
China’s growth rate is impacted due to its internal policy issues. The world started to look at China with scepticism and a lot of companies started to evaluate setting up plants outside China. China is currently dealing with low inflation and low growth. With US and China playing immature trade games, the supply chain globally is under strain.
India’s RBI governor Shantikanta Das has done phenomenal work managing inflation and interest rates. Additionally, the government’s decision to trade with Russia and now with other countries provides good support to INR against USD. Global supply chain disruption finding its way into India can be a game changer. I hope we don’t create another example of lost opportunity the way we did in textile, Bangladesh and Vietnam became recipients.
Now what does all this mean for your investment portfolio?
In the US, the cost of capital continues to be elevated. The market has recovered in 2023 but if inflation is not managed, a lot of froth will settle as the industry profitability may decline.
Although India’s inflation is under control, rising oil prices can put severe pressure on Indian equities. The recent market surge is supported by profitability, but global pressure will continue to prevail, and Indian equities can see some swings.
Indian Real Estate
Although India has seen rising interest rates in the last year, real estate has been on the upswing. The music may continue for some time now. A lot of future disappointment is getting baked into current prices.
Banks have now started offering 6.5-7% FD rates. This is in line with historical trends. Given the global and Indian economic conditions, an interest rate pause is a more probable scenario.
A lot of investors have started investing in US debt because these kinds of interest rates were not seen in the recent past. India and US interest rate differential (GSec 10 yr yield) is at an all-time low. One interesting trend is the difference has reduced not because India has reduced the interest rates, but it's primarily because the US increase the interest rates. What if the US continues to increase the interest rate to manage inflation?
I understand mean reversion, but what if mean reversion does not follow a usual time pattern and it takes longer than anticipated?
Now the other argument is USD appreciation against INR. Historical averages indicate a 4% p.a. USD appreciation. Rising inflation in the USA with India doing INR-based bilateral trade, we will see how the trend emerges. See the chart below, last year is more flattish.
One scenario of allocating in US debt is to pick short-term to medium-term US GSec and link the investment amount to your needs outside India. A lot of old allocation in US debt is still bleeding and the respite is far-fetched.
The world may look like an old version but from an economics standpoint post covid a lot of economists are staring at new developments and only time will tell how it all pans out.
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Details of the advisor
Advisor: Ankur Kapur
SEBI RIA No.: INA100001406
BASL Member ID: BASL1337