“The way to crush the bourgeoisie is to grind them between the millstones of taxation and inflation,” said Vladimir Lenin, the first leader of the Soviet Union. Over a hundred years later, this still holds true, with taxation and inflation silently chipping away the savings of investors. Inflation, in particular, has become a major concern of late with the ongoing Russia-Ukraine conflict causing price instability across the globe.

There is a direct impact of high inflation on investors as it erodes the value of the returns earned from their investments; reducing the real returns. As can be seen in the accompanying table (Inflation and real returns), real return of Nifty 50 turns negative in periods of low nominal return and high inflation as seen in 2002, 2013, 2016 and 2018. Equities need to deliver over 6.5 per cent annually to give positive real return over the long term, if the average inflation over the last 20 years is taken into account.

Investors in fixed income feel the pinch of inflation more since the spread between the nominal returns in fixed income instruments and inflation is much lower. Real yield on 10-year sovereign bonds turns negative in periods of high inflation as was witnessed between 2008 and 2013 (see table). Those parking money in bank deposits suffer more, facing negative real returns on post-tax basis regularly.

Is there a way to reduce the impact of inflation on your equity and debt portfolios?

Inflation outlook

But before we look at that, we need to establish where inflation is headed, at least over the medium term.

If we look at the history of consumer price inflation in India since 1960s, as disseminated by the World Bank, there have been several periods of double-digit growth in inflation, notably in 1973-74, 1980-81, 1991-92. The surge in all these periods was led by crude oil price rallying sharply due to geopolitical crises. While it was Arab-Israel war in the nineteen seventies, the Gulf War and Iraqi invasion of Kuwait were responsible for the price instability in the eighties and the nineties respectively.

The worst period of inflation in India in this century was between 2008 and 2013 when CPI ranged between 8.3 per cent and 11.06 per cent. The price rise then was led by South-West monsoon failure in 2009, higher global demand for commodities following the recovery from the global financial crisis and central bank fund infusions leading to inflationary pressure.

Going by past experience, the current conditions present a perfect storm for triggering sustained high inflation. Supply chain disruptions caused by Covid-19, coupled with surging demand due to revival in economic activity, have been sending commodity prices spiralling since the last quarter of 2021. Fears of trade sanctions on Russia and disruptions in commodities supply from Russia and Ukraine have made prices of energy, agri commodities and metals hit the roof in recent months. Liquidity infused by global central banks is still present in the system, stoking prices.

The RBI has been unusually sanguine about inflation projections, with RBI officials maintaining that inflation is caused by supply disruptions and will subside soon. But going by the scale of increase in commodity prices in March and the manner in which the Russia-Ukraine war is unfolding, it is clear that the central bank will have to revise its CPI inflation for 2022-23 higher from the 4.5 per cent projection made in the February policy.

Many economists are predicting a CPI inflation between 5.5 and 6 per cent for FY23 if crude oil price remains above $100 per barrel. Nomura has been the most aggressive, revising its FY23 CPI projection to 6.3 per cent.

Hedging your equity portfolio

Now, to the critical question, does inflation impact your equity portfolio and what can you do to mitigate the impact?

Company earnings could be hit by inflation in two ways. One, increase in input costs can compress operating margins, especially of manufacturing companies. The EBIDTA margin of Nifty 50 companies, excluding financial companies, fell from 19.86 per cent in FY10 to 16.31 per cent in FY14. This was the period of raging inflation following the Global Financial Crisis. Two, with consumers having lower purchasing power as the value of their money depreciates, they begin reducing non-essential expenditure, thus impacting demand for certain companies.

However, the effect of inflation is not even across all listed companies. While some companies could face margin pressure, others could gain due to higher realisations. A well-diversified equity portfolio, therefore, provides a natural hedge against inflation.

There are some themes that can stand you in good stead in a period of sustained inflation.

Go with market leaders: Companies with deep moats have the capacity to pass on the price hikes caused by inflation to their clients, thus protecting their earnings. It therefore pays to bet on large-cap companies who are market leaders in their segment. The companies in Nifty 50 index discussed above grew their earnings at a compounded annual growth rate of 9 per cent between 2010 and 2014, despite compressing operating margins.

Consumer non-discretionary producers: When purchasing power begins shrinking, the expenditure on discretionary items is more likely to be cut rather than spends on consumer staples. Britannia Industries registered earnings growth of 28.5 per cent and 25.2 per cent in FY12 and FY13 respectively when CPI was close to 10 per cent. In the same period, Bajaj Auto’s earnings growth was -10.05 per cent and 1.3 per cent.

Commodity stocks: Periods of high inflation in India have mostly been led by increase in crude oil and other commodity prices. Having exposure to some large-cap commodity stocks could thus help hedge your equity portfolio from inflation. Oil marketing companies are unable to benefit completely from rising crude oil prices due to the partial control of retail prices by the government and PSU metal producers are weighed down by regulatory uncertainty, but stocks of private sector metal producers such as Hindalco typically perform well in an inflationary environment.

Real estate investment trusts: REITS are held out as one of the inflation hedges in equity portfolio globally. These are entities that own, operate and finance income-generating real estate properties. Not only do investors have a stake in these assets, and thus enjoy capital appreciation, the rental income from these properties is also given to investors in the form of dividend. With rents being linked to inflation, the dividend could also move higher in an inflationary environment. Current dividend yield of the three listed REITs in India ranges between 4 and 6 per cent. Reopening of offices and resurgence in travel and tourism with the ebbing of Covid cases also bodes well for these securities.

Shields for the fixed income portfolio

Fixed income investors need to keep a tighter vigil on inflation for almost all interest rates in the economy are linked to it. As inflation begins creeping higher, policy rates are inevitably moved higher to control it. We are at the beginning of one such policy rate increase cycle now with many analysts expecting three to four 25 basis points increase in repo rate in 2022.

Also, as inflation moves higher, so do sovereign bond yields, resulting in bond prices moving lower (since bond yields have inverse relation with bond prices). There is expectation that the Indian 10-year government bond yield is likely to move to 7 to 7.5 per cent range in the coming months. Aggressive rate hikes scheduled by the US Federal Reserve, the large fiscal deficit of the government and incessant selling by foreign portfolio investors in Indian debt have been applying upward pressure on Indian sovereign bond yields.

What can investors do in this situation?

Go for shorter term deposits: Interest rates of bank fixed deposits, where bulk of Indian households park their savings, have witnessed a steady decline in recent past with weighted average domestic term deposit rate declining from 8.79 per cent in 2013-14 to 5.14 per cent now. Real interest on these deposits turned negative in 2022. The best way to shield your assets from further increase in inflation is by investing in deposits of lower duration so that you can benefit faster from the rate hike cycle, which is about to commence soon.

In this scenario, investing in fixed deposits maturing between 1 and 2 years may be ideal, until the rate hike cycle lasts. You can consider locking into deposits of over 3 years once the rate hike ends, which could be in the second half of 2023 or 2024. This applies to investments in fixed deposits of NBFCs and corporates as well.

Short duration debt funds: Debt fund investors should also consider funds with shorter portfolio maturity. “Conservative investors should stick to liquid or money market funds as these categories tend to gain from rising short-term interest rates,” says Pankaj Pathak, Fund Manager- Fixed Income. Quantum Mutual Fund.

Investors with a higher risk appetite can begin consider corporate bond funds, which hold highest rated securities. The hunt for yields is once again making funds take more credit risk and investors need to tread very carefully here, given the recent Franklin Templeton fiasco.

Puneet Pal, Head-Fixed Income, PGIM India Mutual Fund, too advises investors to look at short duration and corporate bond funds which are actively managed and are running lower duration.

Another strategy that is being presented as a solution to fight an inflationary environment is investment in floating rate funds. These funds invest in bonds whose interest rates are reset periodically. Manish Banthia, Senior Fund Manager, Fixed Income, also advises investing in floating rate bonds issued by companies “as this product benefits from interest rate hikes. Also, given the spread over 6-month T-bill, floating rate bond is attractively placed,” he says.

RBI floating rate bonds: If you are looking for a venue to park a lump-sum at this juncture, then RBI’s floating rate savings bond, 2020 is a good choice. The interest rate on these 7-year bonds is reset semi-annually with a spread of 35 basis points over National Saving Certificate rate. The current interest rate of 7.15 per cent makes it one of the best options with sovereign guarantee. With interest payouts every six months, it is ideal for those looking for regular income.

Floating rate options in small savings: Investors willing to lock their funds for longer duration can also consider Public Provident Fund. Interest rate on PPF is supposed to be revised higher every quarter and is linked to the sovereign bond yield. Unlike most other small savings schemes, the quarterly rate revision in PPF applies to the outstanding investments, making it a better play during inflationary phases. The lucrative tax benefits add to the attractiveness of the current interest rate of 7.1 per cent.

Does gold provide a hedge against inflation?

Gold prices are widely believed to move higher with inflation But empirical studies show that gold prices do not always appreciate in inflationary period or decline when prices move lower in the economy. This is because gold demand is split almost evenly between investors and consumers of gold jewellery. When prices increase, investment demand from ETF investors increases, but consumer demand drops. Similarly, in periods of price decline, gold jewellery demand is high while investors move away. This duality in gold demand mitigates its effectiveness as an inflation hedge.

That said, prices of gold do rise when geopolitical tensions rise or economic uncertainty increases. It is also a good diversifier in your portfolio since its correlation with price movement in other asset classes is relatively low. It therefore makes sense to park around 10 per cent of your portfolio in gold investments, in the form of sovereign gold bonds.