When driving, paying more attention to your rear-view mirror than the road ahead is an unwise thing to do. But rear-view driving gets even more risky if you’re on a ghat road that’s prone to floods, roadblocks and landslides.

If you’re an investor looking to make new portfolio allocations or buy into the market correction today, there’s a ghat road ahead. Tectonic shifts in the macro environment on interest rates, liquidity and inflation are changing the rules of the investing game. This makes past performance a particularly dangerous guide to make your moves for the future.

There are three macro shifts that make the past one, three or five-year returns on stocks, bonds, mutual funds and indeed any asset class today, a misleading guide to the future.

Three shifts

One, global central banks, after being on a rate-cutting spree from 2018 to 2021, are morphing from growth-friendly doves into inflation hawks. The US Fed, which slashed the Fed Funds rate from 2.5 per cent to 0.25 per cent between 2018 and 2020, has quadrupled it 1 per cent in 2022 and plans another 50-basis point hike. Ten-year US treasuries are now offering a 3 per cent yield from 0.5 per cent in mid-2020. When the safest asset globally – the US government bond – suddenly offers better returns, global investors reduce allocations to riskier assets such as emerging markets to take money back home. This is showing up in the FPI exodus from Indian stocks and bonds since October 2021.

Two, global central banks appear fed up with money printing as a strategy to deal with any and every crisis. This is shrinking global liquidity at a record pace. The US Fed is steadfast in its resolve to unwind its $9-trillion balance sheet and stop its bond purchases, despite a war. RBI, too, is pulling back the ₹12-lakh crore excess liquidity it pumped into markets during Covid, with plans to reduce it to less than ₹2 lakh crore. Vanishing liquidity hurts riskier assets more. This is evident in the waning investor fancy for loss-making new-age companies and new-fangled assets like cryptos and NFTs.

Three, inflation rates, which were benign between 2015 and 2020, have flared up sharply in 2021, with the Russia-Ukraine conflict adding fuel to the fire. High inflation hurts the earnings of companies and sectors that use commodities as inputs and prop up earnings of those that produce primary materials. This could lead to a reshuffle in the sectors outperforming in the markets. The earnings impact of this was already evident in the March quarter numbers, but it is early days yet to say if this is a long-term trend or a temporary one.

Here's how the above shifts can impact your portfolio.

Debt over equities

Low interest rates are good for stocks because they set a low bar on the returns that investors expect from equities. With market interest rates at lifetime lows, Indian (and global investors) in the last five years saw their equity portfolios easily beat their debt portfolios.

Category-wise returns from Value Research on May 11, 2022, show Nifty 50 index funds managing 10 per cent, 14 per cent and a 13 per cent CAGR respectively over one, three and five years. In the same period, short-duration debt funds that invest in one to three-year bonds delivered 3.6 per cent, 5.5 per cent and 5.7 per cent.

But this situation is fast-changing. Today one to three-year corporate bond yields have moved up to 6-7.5 per cent and the safest investment in the market — the 10-year Indian government bond — is offering a 7.3 per cent return. This weakens the case for you to own equities for an inflation-matching return. If you’ve so far owned an equity-heavy portfolio, this argues for a more balanced split between debt and equity.

Three macro shifts
Global central banks have become inflation hawks
Central banks fed up with money printing to deal with crisis
High inflation hurts earnings of companies and sectors
Large/mid-caps over small-caps

With a tidal wave of liquidity chasing Indian stocks, the last five years have seen small-cap stocks catch up or even outdo the valuations of blue-chips. Rising retail participation helps the tail-end of the market consisting of small-cap stocks.

This is largely why small-cap equity funds, with their one, three and five-year CAGRs at 14 per cent, 24 per cent and 12 per cent have soundly trounced large and mid-cap fund returns of 9 per cent, 15 per cent and 10 per cent.

Going forward, as liquidity dries up and newbie retail investors retreat from losses, small-cap stocks may suffer disproportionate price damage compared to large or mid-caps. This could reverse the return tables, with small-cap funds likely to underperform large cap and mid-cap ones. This can last quite long — until the bear phase winds down and a new bull market takes wing. Retail investors may also find easy gains from betting on obscure stocks or curated portfolios vanishing, as the indices begin to fare better.

If you’ve over-allocated to small-cap stocks via curated portfolios or direct equities, switch to index funds tracking large or mid-caps for a smoother ride.

Value over growth/quality

When money’s available free and cheap, investors worry very little about the price they’re paying for a company’s future earnings. With cheap and plentiful liquidity, devotees of quality investing have propagated the myth that no price or valuation is too high for ‘quality’ companies.

But in the long run, stock returns are slaves to earnings. The higher your entry valuation for a stock, the higher the growth expectations you’ve built in. Should the growth fail to materialise due to challenging macros, such stocks can suffer a big valuation de-rating, from which it can takes years to recover. It takes only a single governance slip-up or earnings disappointment for a ‘quality’ company to turn into a garden-variety one.

With the cost of money rising, smart investors may look for a higher margin of safety on valuations. This will mean end-of-the-road for companies that combine fancy valuations with poor profit visibility (the new-age tech listings come to mind). The value style of investing (where you look to buy a company below its intrinsic value) has already outperformed the quality style in the last year. As high PE stocks get de-rated, value and contra funds with low PE portfolios may outperform.

Debt fund reshuffle

Rising rates also mean that floating rate funds and funds investing very short-term bonds (liquid, ultra-short, low-duration) can see a quicker reset in returns than funds investing in medium to long-term bonds (corporate bond funds, gilt funds).

Looking at past returns today, credit risk funds owning lower-rated bonds may look more promising than funds investing in government securities, with their one-year return at over 15 per cent against a less than one per cent return on gilt funds. But as yields on 10-year gilts head past 7.3 per cent, it will not be long before investing in long-term gilts will offer better payoffs for investors than taking on credit risk.

Overall, if you’re looking to buy stocks, bonds or funds to capitalise on the recent correction, ignore the rear-view mirror and look ahead!

Related Topics
comment COMMENT NOW