Mutual Funds

How investors can offset inflation

Vinay Joseph | Updated on October 23, 2021

Here’s deciphering performance of different asset classes during varied inflation regimes

Recent news headlines have been dominated by narratives regarding the spike in inflation and whether it is transitory or long-lasting.

Inflation is an important factor for an investor, given that it not only impacts policy making, but also the investor’s expectations regarding asset class returns.

Here’s a deep dive into how key asset classes respond to different inflation regimes. India’s CPI over the last 20 years can be segmented into four distinct inflation regimes.

Low inflation (CPI <4%): India has witnessed extended periods of low inflation, mainly during 2002-2004 and post demonetisation till mid-2019. Bonds recorded their highest returns..

Moderate inflation (CPI 4-6%): India’s CPI has stayed in this range for the maximum period among the different inflation regimes, including extended phases during 2004-06 and 2014-2016. Returns of keyasset classes remained strong in this period.

High inflation (CPI 6-8%): India’s CPI has hovered in this range the least, for a brief period during 2006-2007 and lately since 2019. Bond returns dropped to 5 per cent, unable to beat inflation. Gold delivered its best returns during this period. While rupee weakness helped propel the returns of pharma and IT sector.

Very high inflation (CPI >8%): India’s CPI stayed above 8 per cent only once, but for a very long period between 2008 and 2014. Gold was the stand-out performer during this time, while both equity and bonds delivered sub-par returns and were unable to beat inflation.Defensive sectors massively outperformed cyclical sectors.

The RBI officially adopted the flexible inflation targeting framework in May 2016, with the objective to target CPI inflation at 4 per cent (within +-2 per cent band). This, coupled with other tailwinds like fiscal consolidation, softer commodity price , helped rein in inflationary pressures. India’s CPI has averaged 4.5 per cent since May 2016 compared to its 20-year average of 6.5 per cent. In our view, an inflation-targeting central bank considerably reduces the probability of a revisit back to very high inflation periods (above 8 per cent). However, the ensuing growth recovery from the recent Covid-induced slump and longer lasting benign monetary and fiscal policies both in India and major developed market economies along with rising commodity prices and supply disruptions are likely to keep inflationary pressures high.

Strategies for investors

Increase allocation to equity: An environment of rising growth and higher inflation (our central scenario) is a very supportive backdrop for equity markets. Further, the accompanying rise of bond yields during such periods coincides with rising equity prices.

Diversify equity allocation with a tilt to cyclical strategies: The difference in performance between large-cap and mid-cap equities narrows as we move from moderate to high inflation. Further, a cyclical tilt with exposure to sectors like capital goods, metals and energy, along with banks, aids performance in a reflationary environment.

Corporate bonds could help offset higher bond yields: Corporate bonds, which tend to be more sensitive to changes in growth expectations, do well in an environment of improving growth. They also are lower on duration and less interest-rate sensitive.

Gold, a proven hedge against inflation: Last but not least, history shows gold consistently outperforming other assets during rising inflation periods and, in our opinion, is an important ‘inflation ready’ investment allocation.

The author is Chief Investment Strategist, Standard Chartered Wealth, India

Published on October 23, 2021

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