What is a hedge against persistent inflation?

Given India's inflation history, equity despite its volatility may actually be the safest investment for an individual

Over the past 20 years starting December 1993, the wholesale price index (WPI) registered a CAGR (compound annual growth rate) of 6.6 per cent. Across the same time, the consumer price indices (CPI) had CAGRs of between 7.5 and 8 per cent (India used several CPI baskets targeting different population segments).

If those numbers are roughly accurate, we can deduce some things. One is that inflation has been consistently high. The second is that the difference between WPI and CPI has usually been between 1 per cent and 2 per cent.

The last few years have seen changes in pattern. Inflation has remained high. But the differential between CPI and WPI has widened. Since April 2011, the CPI has trended above 10 per cent and at about 3 per cent higher than WPI.

The WPI represents costs to manufacturers and wholesalers. If they pass on cost increases and keep reasonable margins, the CPI is likely to run a little higher. Calculations are complicated because baskets have different weights for various items.

Food weighs in at almost 50 per cent of the CPI basket in the new unified CPI, while it is about 14 per cent in the WPI. This accounts for much of the widening differential. Food retail prices have shot up with 100-150 per cent premiums on wholesale rates.

India calculates its GDP growth after adjusting for WPI. Most nations calculate GDP growth on the basis of their respective CPIs. If India used a CPI deflator, GDP growth would be reckoned at about 1 per cent less per annum across the entire liberalisation period. Between 2011-12 to 2013-14, GDP growth would have dipped drastically if CPI was the benchmark.

Since the CPI reflects inflation as experienced by consumers, it is an indicator of sentiment. If GDP growth net of CPI is low, consumer sentiment trends down. This has political implications of course. Also, when sentiment is low, consumption demand drops.

Obviously, policy-makers must fix the food situation as well as tackle other causes of persistent inflation. Equally obviously, nothing tried in the past three years has worked. Massive reforms would be required across the food value chain in various states and no political party seems to have the courage.

What can the individual do to hedge against persistent inflation? Any financial plan must aim for returns above inflation. Individuals must target the CPI rate. That means aiming for compounded returns of over 8 per cent per annum, and ideally, for returns of above 10 per cent.

There are very few instruments that deliver this return consistently. Vanilla debt will never meet these needs. Bank fixed deposit rates are usually well below the prevailing inflation. Corporate bonds might offer higher rates but the bond market isn't well developed and there are risks of default. Debt funds offer great returns during periods when interest rates trend down but they lose money when rates go up. Given the inflation history, there are likely to be fewer periods of rate reductions compared to periods of hikes. The RBI's new inflation-adjusted bonds are tied to CPI and offer a premium of 1.5 per cent over CPI. These instruments are being distributed via banks, which see them as direct competition to fixed deposits. So they aren't being pushed.

Equities, gold (more broadly precious metals), commodities and real estate are the other asset classes which individuals can invest in, hoping to beat long-term inflation. The return profiles are interesting.

Gold generally doesn't beat inflation (it doesn't earn interest) and prices can stay flat for decade-long stretches. Once every 20-odd years, gold seems to have a massive bull run. If you get in at the right time and exit at the peak, that's great. Commodity investing requires very smart picking and good timing. Specific commodities will beat inflation at specific times but you have to zero in on the right one at the right time.

Real estate beats inflation if it's bought at the right stage in the boom-bust cycle. This means the buyer should wait for a price correction and, if mortgaging, buy when rates look likely to drop. But real estate is lumpy and acquisition prices can't be averaged down in a falling market.

Equities consistently beat inflation over the long term. A passive equity index investor who is buying systematically will beat inflation over decades. He is automatically averaging price. The Sensex and Nifty have yielded CAGRs in the range of 12 per cent over the past 20 years. That is a premium of 4 per cent over CPI. Given India's inflation history, equity despite its obvious volatility may actually be the safest investment an individual can make.