A world of negative real rates

Returns elsewhere are so low, and risks so high, that Indian equities have a chance to shine

Most global portfolio managers, pension plans and other such real money investors have the choice of a whole slew of assets to invest in. Their potential investment options can be thought of as sitting on a risk-return curve, moving upwards in both dimensions. At one end of the curve, you can have cash in the bank (the lowest risk and lowest return). The curve moves up to government bonds, investment-grade companies and high-yield debt; then equities and private equity; and finally culminates in venture capital (the highest risk and highest return). This risk-return curve, of course, only applies to financial assets - real asset investments such as real estate, timber and gold find their own place. Also, depending on valuations, the stage of the economic and business cycle, risk aversion, investor positioning and so on, these financial assets can move up or down the curve and change their relative positions.

For most of the past few decades, investors in financial markets could safely assume that across an economic cycle, all these investments would deliver a positive real return, largely determined by the extent of risks taken. Diversification across this risk-return curve made sense, largely driven by the extent of risk appetite an investor possessed and the required real rate of return. In fact the role of the asset allocator was to largely optimise portfolio positioning along this risk-return curve to take advantage of any anomalies, and maximise return per unit of risk taken. Depending on risk appetite, return expectation and mandate, allocators would invest across the financial asset spectrum.

Out of a total estimated $209 trillion in global financial assets (excluding real estate), approximately $52 trillion is in equities, $45 trillion in government debt, $46 trillion in corporate debt and $65 trillion is in loans (source: GaveKal). Therefore, roughly 25 per cent of all global financial assets are in equities (higher risk/return), and the balance is in debt of one form or another.

While the existing asset mix is perfectly rational given the type of returns these different assets have generated historically, it may no longer make sense if we look at the type of real returns on offer today. Globally, central banks of advanced economies are guaranteeing you negative real returns, with the objective of kick-starting growth. We have a great monetary easing in operation, with most central banks engaged in some type of asset buying/currency printing. Financial repression is in full swing. With the real returns on offer today, 75 per cent of global financial assets are locking in losses in real terms. The only way these losses will not come to transpire is if inflation were to totally collapse and deflation set in. For example, with the current five-year US Treasury note yielding about 0.7 per cent and inflation near two per cent, anyone buying this note today will be hit with a loss in real terms from day one. Given where interest rates are, it is impossible to get any returns in real terms in any fixed-income instrument in the more liquid advanced economy financial markets. Investors need to either add huge duration risk (extending tenure) or credit risk to get any real returns at all. Otherwise, if they are to make money, they have to assume the whole world is going to go the way of Japan, with an extended deflationary bust.

This explains the huge surge in perpetual bond issuance as well as the almost incessant supply of lower-quality corporate paper and the desperate grab for yields. The International Monetary Fund has already warned that financial markets are seeing debt issuance trends reminiscent of the last stages of a debt market bubble in terms of quality of paper, yields and covenants. There has been no better time for any corporation to issue long-dated paper.

Given that all government paper and most investment-grade corporate paper in all advanced economies are guaranteed to lead to loss of money in real terms over the coming years unless the world goes into a deflationary spiral, you would expect a huge move by asset allocators up the risk curve. They will need to move into equities just to protect their portfolios and make any returns, and this forms the basis for the great rotation argument (from bonds into equities) everyone has been highlighting for the last few months.

With losses in real terms almost guaranteed for fixed-income investors, one has to hope that these investors make this move into more risky, higher return assets and do not fall into the trap of becoming even more risk-averse in portfolio construction. Facing real capital destruction in their core portfolio, many pension funds may decide to batten down the hatches and take no risk at all. Instead of buying more equities, they may decide that they have no risk appetite and cannot take on the volatility. Such an outcome, were it to happen, would be a serious negative for global growth and all risk assets - it would be the great rotation in reverse. I don't think this is the base case. Allocators will try to protect their portfolios and maintain capital in real terms, for which they will have to move up the risk curve.

I think asset allocators will be forced to move into equities. With this move, flows into emerging markets will be robust. Though emerging market equities have underperformed for some time now, and there are serious questions about the outlook for the asset class and the whole BRICS concept, equity inflows and performance will rebound. The initial move into equities will be more concentrated in the US and Japan, but will eventually flow into emerging market equities.

It is here that India has a real chance to shine. Both China and Brazil have serious structural challenges. China is handling the transition to slower, more consumption-oriented growth from a very capital-intensive, investment-led growth model. Such a transition is bound to cause hiccups and create volatility. Brazil runs the risk of catching the Dutch disease, wherein the expansion of the commodity sector comes at the expense of the manufacturing sector, which experiences a serious terms-of-trade shock. Russia has similar challenges of being over-dependent on oil, and Korea faces the problem of the yen's depreciation and its impact on the country's export champions. The Association of Southeast Asian Nations (Asean) now looks over-hyped and expensive. If we can get our act together in terms of governance, we will be positioned as a better story than most of the other large emerging markets. Most investors recognise that India is more a case of self-goals than one of a hopeless structural problem - many of its problems can be addressed through some political will. Will we let yet another opportunity pass us by?

The writer is fund manager and CEO of Amansa Capital