With inflation in the doldrums between 2014 and 2020, Indian investors did not have to worry about whether they were investing in asset classes that fetched them a good real return (return over and above inflation).
But this is set to change, with sticky global inflation re-emerging, driven by a range of commodities from copper to cooking oil to steel.
Though RBI/MPC have been hoping that the spike in India’s CPI (Consumer Price Index) will be fleeting, it has proved stubborn averaging 6 per cent in the last twelve months.
So, if a resurgent global economy does trigger a high inflation phase, which assets should you own more of, to earn inflation-beating returns? Instead of relying on theory, we decided to rely on past data to find answers.
India encountered a long stretch of high CPI inflation averaging 10.4 per cent in the five year period from January 1 2009 to January 1 2014 and we ran returns on different assets to find the following.
Bonds, FDs?
When inflation is on the rise, central banks usually raise policy rates to quell it. This makes it a bad time to own bonds, as rising rates lead to declining bond prices.
With the Indian economy in shambles post-Covid, RBI/MPC may be late in hiking their rates in response to inflation today.
But even if policy rates do not rise in a hurry, market interest rates (such as the 10-year g-sec yield) can spike if inflation is perceived to be sticky.
Had you held Indian government securities (proxied by the CCIL All Sovereign Bond Index) during the period from 2009 to 2014, you would have earned just a 3.2 per cent CAGR, a significant negative real return.
If you believe that high inflation is here to stay, it would be best to stay off long-term g-secs and long-dated corporate bonds.
Bank FD rates are usually a little higher than sovereign bond rates, but not enough to beat inflation.
This time around, with policy actions likely to be delayed, bank FD rates may not keep up with inflation.
RBI data on deposit rates of banks for 1 year periods, shows that in the 2009 to 2014 period, bank FDs returned a healthy 8.6 per cent, but this still lagged CPI inflation of 10.4 per cent. Today bank FD rates are scraping 5-6 per cent. They are unlikely to deliver real returns, should inflation spike.
Equities
Equities are said to be the best asset class for inflation-beating returns, based on the textbook premise that in the long run, stocks must deliver a return premium over bonds to compensate for higher risk.
While this may be true over 10-year plus holding periods, over shorter times, stock performance need not keep up with inflation rates.
Stock prices track earnings growth. Rising prices of industrial inputs such as petrochemicals, chemicals and industrial metals can hurt the profitability of companies using these inputs unless they are able to pass them on in full to their customers.
Given the weak demand outlook after the Covid second wave, Indian companies in a majority of commodity-using sectors are likely to see some profit impact from rising input costs. Commodity-mining or processing companies however, could enjoy windfall profits.
In a high-inflation scenario, selective bets on stocks of commodity processors may pay off better than those of commodity users.
In a recent India Strategy report, Motilal Oswal found that while 11 of the Nifty companies benefit from rising commodity prices, 13 are adversely impacted and the rest tend to be neutral.
A high inflation scenario may call for reducing bets on auto, FMCG, consumer durable companies while raising them on steel, cement and upstream oil plays.
Small and mid-sized companies may enjoy lower pricing power and may be more hurt by input inflation than industry leaders.
However, commodity companies by virtue of sheer size tend to dominate Nifty earnings, by contributing 36 per cent of the profit pool.
In the inflationary period from 2009 to 2014, the Nifty50 Total Returns Index and Nifty500 Total Returns Index managed a 17 per cent CAGR, easily beating the 10.4 per cent inflation rate.
But equity performance then was underpinned by a low starting point. In 2009, after a big bear market, Indian stocks traded at low valuations (Nifty50 PE was 13.3 in January 2009). Today, market valuations are at record levels of 29 times (Nifty50) after a multi-year bull market.
This makes high real returns from equities as a class less certain. A selective approach of betting on commodity-makers or companies with pricing power, may work better.
One of the viable routes to acquire such exposure is to invest in thematic commodity equity funds.
Commodity funds with an international flavour, which offer dual exposure to global commodity giants and the US dollar, have in the past proved good bets in inflationary times.
In the 2009-2014 period, Aditya Birla Sun Life Global Commodity Equities Fund- Agri Plan managed a 14.4 per cent CAGR.
Gold
Gold is supposed to be a classic inflation hedge. But gold for Indian investors hasn’t always kept pace with inflation on a year-to-year basis. Broadly though, inflationary trends globally do spark investor interest in gold. For Indian investors, periods of global crisis or commodity price surges are usually accompanied by Rupee depreciation.
With these twin tailwinds, high inflation years from 2009 to 2014 did prove bumper years for Indian gold investors. Gold ETFs delivered a 13.2 per cent CAGR.
Raising gold allocations is therefore a good idea if you believe in the return of inflation.