Ever wondered why equity corrects when interest rates rise or why gold prices rise when stock markets fall?
Aleksha Bindal is pleased to put her money in a fixed deposit of a private sector bank fetching 9.5 per cent annually. She had never seen such rates in past two years since she started investing.
Bindal had also put money in equities, which was down by 20 per cent. She is in a dilemma whether she should shift her equity portfolio to debt or continue to be invested in equities.
Another thought she had was do a tactical shift in her asset allocation to suit the current investment environment but she couldn’t make up her mind on the balance she should maintain between asset classes. If you have a similar dilemma and want to know the dynamics of the various markets, read on.
Various markets are intertwined. Normally, when the interest on fixed income instruments goes up, the equity market is down. Similarly, when the equity market is down, gold is up. An example should explain why this happens.
Assume company A has equity capital and debt of Rs 100 crore each. Its earnings before interest and tax is Rs 20 crore. The interest on borrowings is 10 per cent a year. The earnings after interest and before tax will be Rs 10 crore. Assume the interest on borrowing goes up from 10 per cent to 12 per cent.
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The earnings after interest and before tax will go down to Rs 8 crore. Thus, in a rising interest rate scenario, the bottomline of companies fall. Similarly, in a falling interest rate scenario, the bottomline grows. As a result, the share price moves up due to better valuation when the interest rate moves down and goes down when interest rates go up.
The changes in rates affect the value of companies and their shares. This is because; a company’s share market value is its projected future cash flows, discounted to the present, using the investor’s required rate of return.
If interest rates fall and everything else is held constant, the share value should rise. That’s why the market cheers when the Reserve Bank announces a rate cut. Conversely, if the RBI raises rates (holding everything else constant), share values fall.
Another reason for the inverse relationship is that more money will be diverted to fixed income instruments when interest rates are moving up, which affects liquidity in the equity market.
There is an inverse relationship between commodities like gold and equities. Gold acts as a store of value. During inflationary times, interest rates move up, resulting in lowering of equity values. As a result, more money is invested in gold to protect value. Also due to inflation, people prefer to put money in gold, as it is a hedge against this (the current market scenario resembles this situation).
To look at the correlation between the Nifty, the gold price and interest rates, we have tabulated the values of the S&P CNX Nifty, Gold BeES (Gold Benchmark Exchange-Traded Scheme) and State Bank of India’s deposit rate for a one-year deposit. (Table: Domino Effect) A look at the historic data brings out the variation in the movement of the S&P CNX Nifty values, gold prices and interest rates. We assessed the relationship between the three at the end of every year from March 31, 2007, till date.
As can be seen from the table, the value of the S&P CNX Nifty, Gold BeES and interest rates moved up in 2007-2008 due to bullish sentiments in all markets. In 2008-2009, the Nifty value was down by 36 per cent, whereas Gold BeES was up by 24 per cent, showing the inverse relationship in the two markets. The interest rate were more or less stable during the period. In 2009-2010, the Nifty value was up by 74 per cent, whereas Gold BeES was up by only 7 per cent, showing the inverse trend in the two markets. The interest rate fell drastically to six per cent: again, it showed the inverse relation between interest rates and the equity market. In 2010-2011 till date, the Nifty value has increased only by nine per cent, whereas Gold BeES is up by 23 per cent and the interest rates have moved up by 225 basis points.
| DOMINO EFFECT | |||
| Particulars | S & P CNX Nifty | Gold BEES | SBI rates * (%) |
| Mar 31, 2007 | 3,822 | 948 | 8.25 |
| Mar 31, 2008 | 4,735 | 1,212 | 8.75 |
| Mar 31, 2009 | 3,021 | 1,500 | 8.50 |
| Mar 31, 2010 | 5,249 | 1,608 | 6.00 |
| Jan 20, 2011 | 5,712 | 1,978 | 8.25 |
| *Interest rates for a one-year deposit | |||
Except for the financial year 2007-2008, the inverse relationship between equity and gold and equity and the interest rate is clearly brought about.
The correlation shows that investors should not put all eggs in one basket. Whether any market is doing really well or not, there should be a certain allocation to be made. It protects us from any downside in one particular asset class.
Building a suitable mix of investment across various classes of assets like debt, equity, real estate, gold and so on. Even among the broad asset classes like debt or equity, there are sub-classes.
In equity, one has to diversify across large-cap, mid-cap, small-cap, sector-specific, various mutual funds, and so on. In fixed income, an investor must invest suitably in various instruments such as bank fixed deposits, NSC, KVP and PPF.
From the example, it can be seen that the investor who invested in equities in March 2009 is reaping a bumper windfall even now. Similarly, in a four-year period, gold has doubled its value, whereas the S&P CNX Nifty has increased by only about 50 per cent. Putting money in a fixed income instrument enables you to have an assured fixed income, safety of capital and at times earn better returns when the rates are high.
The idea behind diversification is primarily to ensure the different assets in one’s portfolio do not move in the identical direction at all times. If so, there would be no hedge against losses.
The writer is a freelancer
| TAKEAWAYS # Various markets are intertwined and affect each other # Normally, when the interest on fixed income instruments goes up, the equity market is down # When the equity market is down, gold prices are up # Diversification helps to tide over imbalances of various markets # Investors need to diversify across sub-classes of a particular asset class |