A diversified portfolio could be best bet against steep inflation: Experts

Consumer Price Index (CPI)-based inflation rose to a six-month high of 6.3 per cent in May. With returns on many fixed-income products turning negative – the interest rate on State Bank of India fixed deposits for the 5- and 10-year tenures is 5.40 per cent – investors are a worried lot.

Potential risks 

Many experts believe the current phase of inflation may not be transient. “Among food products, prices of protein items may stay up. Brent crude is at around $74 per barrel but could move up to $78-80. High fuel prices would raise transportation costs, which would in turn have a cascading impact on prices across the board,” says Joseph Thomas, head of research, Emkay Wealth Management.

Supply bottlenecks also pose a challenge. “As the economy reopens and demand rises, we could see inflation on the services side due to supply bottlenecks. If demand revives, companies could pass on costs to consumers as many face margin pressures,” says Pankaj Pathak, fund manager – fixed income, Quantum Mutual Fund. He expects inflation to average 5.90-6 per cent in FY22.

Inflation has breached the upper limit of the Reserve Bank of India’s tolerance band at a time when the economy is growing below its potential. High and sustained inflation could even affect gross domestic product (GDP) growth. “It affects purchasing power and leads to a fall in consumption as people postpone expenses. This affects economic growth. This is why analysts have reduced their GDP growth assumptions for FY22 to 8-9 per cent,” says Thomas. Lower growth could affect corporate earnings too.

How to tackle inflation 

Experts say a diversified, long-term portfolio is investors’ best bet against inflation.

Equities: A portfolio with adequate exposure to equity mutual funds has the potential to provide protection against inflation over the long term (see table).

However, high and sustained inflation impacts equity markets in the short run. “Equities tend to do well in the earlier part of the inflation cycle as pricing power comes in the hands of companies. But in the later part, higher inflation leads to higher interest rates. As interest rates move up, discounting happens at a higher rate, so equity valuations tend to move down,” says Gaurav Awasthi, senior partner, IIFL Wealth.

If inflation remains high, global central banks could taper rates faster, which would impact valuations. If there is a correction, investors must continue with their equity allocation.

“Investors who are investing on their own may opt for dynamic asset allocation funds, which allocate to equity on the basis of valuations,” says Vinay Paharia, chief investment officer – equity, Union Asset Management Company. 

Some investors may be tempted to increase their equity allocation. This is not advisable. “If you have been advised a 50 per cent equity and 50 per cent debt allocation, stick to it. Someone who is at 20 per cent equity exposure may increase it to 40-50 per cent, provided he has the risk appetite,” says Avinash Luthria, a Sebi-registered investment advisor and founder, Fiduciaries.

International equities: If inflation remains high for long, the rupee would correct. A foreign currency-denominated investment would then provide a hedge. “Though the US too is facing inflation, in the long run one can expect it to be lower in a developed market like the US than in India,” says Luthria. He suggests investing in a passive fund based on the S&P 500 or the Nasdaq 100.

Debt funds: Some hardening of interest rates is expected over the next year. “Avoid long-duration funds as they could turn very volatile in a rising rate scenario,” says Pathak. Use a combination of lower-duration debt funds and hold-to-maturity (HTM) products. “The modified duration of lower-duration funds should be less than one year. Invest in target maturity debt funds if you have a longer horizon,” says Vishal Dhawan, chief financial planner, Plan Ahead Wealth Advisors.

A few other fixed-income products can also provide inflation-beating returns, like Public Provident Fund and Sukanya Samriddhi Account. The Senior Citizen Savings Scheme (SCSS) and Pradhan Mantri Vaya Vandana Yojana (7.4 per cent taxable return), GoI Savings Bond (7.15 per cent taxable) may also beat the long-term CPI-based inflation rate of 5.9 per cent for those in the lower tax brackets.

Gold: Gold has traditionally been a good hedge against inflation and has a negative correlation with equities. But it also has prolonged bull and bear cycles. Experts suggest a 10 per cent exposure to gold.

Real estate investment trusts (REITs): Investors in need of regular cash flows may invest in REITs. “They have the potential to offer inflation-hedged returns over the long term. REITs can constitute 10-20 per cent of an investor’s debt portfolio. One can expect 7-9 per cent pre-tax return from them,” says Awasthi.

Finally, do tight household budgeting: while inflation is beyond your control, cutting down expenses is not.