Warren Buffett once said that the one piece of macro-economic information of paramount importance to an investor was interest rates. Even if an economy is growing fast, it may still be an unattractive investment destination if the interest rates are at the wrong level.
Interest rates determine the asset mix. Every investment strategy starts with benchmarking to the risk-free interest rate. If that’s high, the return from other riskier assets has to be even higher. The ideal situation for equity investments is an economy with high growth and low, preferably falling interest rates. There may be times in the business cycle when real interest rates are negative and growth is high. That’s the sweetest of sweet spots for an investor.
In the past two years, interest rates have risen consistently across all rupee instruments. Both corporate and GDP growth has slowed through this period. However, once we adjust for inflation, real interest rates have been very low or negative for a while.
The risk-free return differs for different investor segments because institutions have easier access to government debt market. For an institutional investor, the yield on a 364-day treasury bill could be a good proxy for the risk-free return. The T-Bill rate has been above 8 per cent for the past year.
For a retail investor, the yield on a one-year fixed deposit is a better proxy for the risk-free rate since it’s not so easy to buy T-bills. The mandated Provident Fund rate is higher but there’s a limit on the amount an individual can invest in PF. One year FD rates are around 7.5 per cent.
It can be argued that the effective rate of inflation also differs for different segments. For a retail investor, inflation is best tracked in terms of the Consumer Price Indices (CPI). There are several CPI series - all have run at close to 10 per cent, or higher. Hence, the real interest rate has been negative for a while for retail investors. Incidentally banks and NBFCs have charged a generous spread over their borrowing costs.
The Wholesale Price Index is more generally taken as the inflation indicator. That’s been over 7.5 per cent consistently. Assuming the WPI is the better inflation indicator for an institution, interest rates have been quite low, and occasionally dipped into the negative zone for institutions.
In real terms therefore, debt is offering very low or negative returns and has done so for a while. This would normally increase the temptation to move towards equity and other instruments offering higher returns for higher risks. However, the falling growth trend has retarded such a shift in allocations. Earnings projections have been pared down and share prices have fallen.
Indian investors have been faced with an unenviable choice for a while. They could stick with debt, protecting the principal. But that means a gradual erosion in real portfolio values because of high inflation. Or, they could shift to equity, which means potential capital erosion in a bearish market.
Among other assets, real estate is inversely correlated to interest rates. It’s been struggling as an industry.
Realtors have difficulty accessing credit and pay very high rates, due to RBI prudential norms. Demand from buyers has been slow due to high lending rates. Gold has made significant gains but is looking increasingly risky as price has soared.
In the circumstances, the investor needs to wait until rates come down, or growth accelerates. There are signs that the interest rate cycle has peaked, although the RBI is reluctant to cut rates just yet. The chances are, rates will ease before growth sees a turnaround.
Core inflation, stripped of food and energy, is already down. This is no surprise, given low overall growth and a flat index of industrial production. The soft global economy has led to lower crude prices. Despite the weak rupee, this means less inflationary pressure on the energy front. If the monsoon is reasonable, food prices would also ease down.
If the trends mentioned above continue for another quarter (implying a decent monsoon), lower rates become likely. Lower rates would create a compelling case for larger allocations into equity. Apart from changing the risk-reward matrix in favour of riskier assets, lower rates should mean banks and NBFCs cut their lending rates. That could create consumption demand and reduce the interest burden on corporates.
So, these are the signals investors will now have to watch for. A decent monsoon, a trend where Brent crude prices stay below $100 a barrel and lower rates. When all three signals go green, it’ll be time to go overweight in shares.
