• Investment World
• eWorld
• Catalyst
• Mentor
• Life
• Canvas
• Praxis
• Urban Pulse
• Brand Quest

Suresh Krishnamurthy

Profits from industry's core operations are now growing at a robust rate, though risks such as strong oil prices and fiscal profligacy persist. Given the backdrop of rising rates, the ideal strategy would be to go overweight on equities as return from equities is likely to be much better than that on debt.

FINALLY, Indian banks have jacked up the rates on deposits. The real rates are, however, still below what can be considered as reasonable compensation. The scope for a further rise in real rates is thus strong. Whether they rise due to a decline in inflation or an increase in interest rates remains to be seen.

Thus, following years of low or negative real rate of return we may be embarking on an interest rate cycle that produces a reasonable real rate of return on debt investments. This could also be a positive for equities.

Everything, however, hinges on industrial activity and fiscal prudence. The upturn in industrial activity, the predominant consumer of capital, needs to be sustained. The Government too needs to turn into a more efficient consumer of capital. If these outcomes obtain, it could turn out to be a good time for investments.

Real rate: Simply put, the real rate is the difference between interest rate and inflation rate. The average rate of inflation was below 5 per cent in the past couple of years while the one-year term deposit rate was above 5 per cent. Real returns were thus positive for investment horizons above one year and negative for investments below one year.

In the past six months, though, things have turned worse for debt investors. Average annual inflation is expected to be above 6 per cent, while one-year bank term deposit is only at about 5 per cent even after the increase in interest rates effected now.

Many mid-term debt investments are underwater, earning negative rates of return. In addition, there are many who believe that over the past few years, real returns have actually been negative and official statistics understate inflation.

The worst may, however, be over from the real rate perspective. Increases in industrial activity followed by a robust increase in the value added by the industry will have to be shared with various factors of production, which include capital.

A fair share of the increase in value added is bound to filter down to debt investors given that industry could turn out to be the predominant consumer of capital.

Positive for stocks: Any increase in interest rate is bound to affect the value of stocks. Cash flows are discounted at a higher rate and these might mean lower prices. The prognosis for these investments, however, could turn brighter if the momentum in industrial activity is sustained.

Profits of industry from core operations are now growing at a robust rate. If the upswing in the investment cycle is not cut short by other factors, the growth momentum could be sustained.

The impact of a higher rate on valuations could be more than offset by the strong growth in profits. It has been seen in many countries that the start of an interest rate upswing is also the time when valuation of stocks improve.

There is also the impact of the liberal taxation regime. Taxes on short-term and long-term gains have been reduced considerably. This alone could completely offset any increase in interest rates.

Risks to growth: Risks to such a benign scenario do exist, the first of which is oil prices. Strong oil prices could derail industrial growth. These could deflate the entire growth momentum. Interest rates would then stay stable and stock prices would retrace to lower levels.

Fiscal profligacy is another factor. If inefficient spending leads to increased borrowing then the outcome would be extremely detrimental given the strong oil prices. In that kind of a scenario, stocks would stagnate and real returns from debt would continue to be low or negative, though interest rates could rise from present levels. This is the worst scenario.

Factors such as momentum in corporate profits, the decline in oil prices and robust credit offtake, however, paint a positive picture as of now.

Overweight equities: Given the backdrop of rising rates, the ideal strategy would be to go overweight on equities, that is invest more in equities than you would have otherwise done normally. This is because, going forward, return from equities is likely to be much better than the return on debt.

Article E-Mail :: Comment :: Syndication :: Printer Friendly Page

Stories in this Section
Investment Quiz

Copyright © 2004, The Hindu Business Line. Republication or redissemination of the contents of this screen are expressly prohibited without the written consent of The Hindu Business Line