A sit it out strategy

A long-term investor has to be ready to weather any storm

The bond market has been emitting bearish signals for months. Those signals got stronger as the 10-year government bond (2028) yield touched 8 per cent in early September. This was the highest yield since December 2014. 

A year ago, the benchmark bond was yielding about 6.5 per cent. The RBI has since hiked policy rates by 0.5 per cent. The excess in the bond’s yield can be explained by bearish expectations caused by rupee weakness and fears of rising government borrowings. 

Traders are braced for inflation.  Although the August Consumer Price was down, September inflation trends will definitely be higher than August.  Apart from higher fuel prices, auto manufacturers have hiked prices, as metals and electronic components have become more expensive. Rubber and coffee prices have started rising as supply is cut due to floods in Kerala and Kodagu. Major lenders, State Bank of India and Housing Development Finance Corporation have raised deposit and lending rates. 

Many traders are assuming the Reserve Bank of India (RBI) will hike policy rates in early October, at its next review, despite the August moderation. Growth is strong.  Base effects pushed Q1, Gross Domestic Product growth rates to 8.2 per cent, and Q2 growth is likely to be high as the base effect continues. Even adjust for a fadeout of base effects, the central bank has reason to hike.  

The bond market is expecting a huge spurt in government borrowing in the second half. Gross market borrowing of states and centre combined may cross Rs 12 trillion.  Rising crude prices could force a larger quantum of borrowing. This will crowd out private borrowers and drive up yields further. 

There is a ticklish problem with currency management. The RBI cannot let the currency slide much further and, at the same time, it would be unhappy about spending huge sums of forex to defend the rupee. A higher policy rate may help stabilise the rupee.   

If the RBI does hike, and government borrowing is on predictable lines, bond market yields will climb. That will have knock-on effects. Financial sector businesses - banks and non-banking financial institutions - will struggle. Apart from accepting mark-to-market losses on current portfolios, they will see business volumes suffer.  More corporate defaults are also likely. On the consumption side, household demand, which has been driven by borrowing, may contract. 

What this will do to a stressed banking sector is anybody’s guess but it won’t be pretty. Pending Insolvency and Bankruptcy Code cases will see lower bids, meaning lenders may be looking at deeper haircuts.  The timeline for the resolution of the massive overhang of non-performing assets may rise. Lenders will inevitably get more cautious about sanctioning credit to big projects. 

If we run through the traditional list of investments, investors rebalancing portfolios at the half-year mark, might look to lighten up on debt. Debt funds are looking quite dangerous. There has already been a big shift out of medium-term and long-term debt into liquid money-market funds, where the rates may remain relatively unaffected.  Debt funds may see even higher redemptions.  

Most equity investors are fully committed directly, or via mutual funds. The overall equity market has not done well in the last couple of months, notwithstanding the rising Nifty. Systematic Investment Plans may continue to flow at the current rates but inflows are not likely to rise. 

The real estate market has been nearly static, so real estate is not looking attractive. That market is also very sensitive to higher rates.  Retail investors have been uncomfortable about fixed deposits in the last year, and seem to be holding more cash, going by the RBI Annual Report. There may be some investors who are tempted back into fixed deposits by higher rates. 

There are also chances of investors buying gold, which is looking increasingly like a potential safe haven. Legal gold imports jumped to a high of 100 metric tonnes in August - more than twice as much as the 46 tonnes imported in August 2017. It’s possible that September will see equally high gold imports since lower international prices have balanced off the stronger dollar. 

The long-term equity investor just has to ride out phases like this even if a deep correction occurs. But a large proportion of India’s investors are not long-term oriented. If there’s several months of poor returns, that could trigger a cascade of selling. Be prepared for that.