The policy actions of the past three weeks have probably staved off a sovereign downgrade for the moment at least. This gives the government a few months to try and improve the twin deficits that have brought India to the edge of junk status. Whether it can do so is a big question.
If there is no downgrade, implying public finances do show some signs of improvement, the bull run in equities will probably continue. If India does undergo a downgrade, it would trigger off another bearish phase because an entire class of foreign investors would have to pull out.
This possibility causes a conundrum for retail investors. A sovereign downgrade is the classic risk that cannot be diversified away in that it affects more or less every business operating in India. So there’s a big potential downside. The risk is actually higher now due to the 7 per cent spike in equity prices in the past three weeks.
If a downgrade does happen, every rupee portfolio will get hit to some extent regardless of relative asset allocation. The equity component would suffer capital loss while the debt component would be hit by a combination of sharp currency depreciation and the likely interest rate volatility and rate hikes that would occur after India achieved junk status.
There is no real way to plan for such a situation. In such a contingency, the best hedge for an Indian investor would probably be to take long trades in the currency futures market, betting on the rupee falling. The alternative hedge of holding a high bullion component at these record gold prices carries its own dangers.
Let us suppose that a downgrade to junk doesn’t occur and India comes back from the brink. Real economic growth and improvements in public finance ratios may be a gradual process in that case. But the stock market is likely to continue its rally while the economy trundles along because there will be plenty of liquidity to flow into the stock market.
Any serious improvement in the Indian economic outlook is likely to be buttressed by interest rate cuts. Cuts in rupee policy rates will have interesting implications, as and when they do happen. In the last year alone, domestic and foreign institutional investors (DIIs and FIIs) have bought over Rs 500,000 crore worth of debt instruments. In the past three years, as the RBI has successively hiked rates, they’ve bought a lot more than that. Much of this is government debt but that’s incidental.
The value of that debt portfolio will rise if interest rates fall. It holders so choose, they will be in a position to cash it in and take a capital gain. If a cycle of rate cuts starts, there will be debt investors prepared to do just that. The money, which is released into their hands, may well flow into equities. If this happens, we’ll see a big bull run with both FIIs and DIIs prepared to invest in equities at whatever the prevailing rates are. This sort of liquidity-based rally makes value investors nervous. But it could be a move of great magnitude.
Just as the rate hike cycle has lasted for several years, it’s perfectly possible that a rate cut cycle could last for a similar length of time. There’s room for policy rates and Treasury Bill yields to halve from current levels of above 8 per cent. In the last two cycles, GoI yields bottomed at around the 3.5-4 per cent levels or lower. This means there’s also room for commercial interest rates to fall a very long way.
During the early stages of a rate cut cycle, there would be a large rally in the bond market. Every debt fund dealing in medium-term and long-term debt would find itself in a position to deliver much higher NAVs on capital gains alone. So a retail investor would get the option of buying into debt funds or buying into equity with strong prospects of capital gain in both cases.
When will the RBI cut? This is the tough question to answer. The central bank could cut in October itself or it may choose to wait a little longer. The point is, it is very unlikely to raise rates now. So investments in debt funds look reasonably safe.
It may be time to move some money from fixed deposits into equity or a debt-fund portfolio. You may have to wait and hope that a sovereign downgrade doesn’t occur. That is the really large risk. There is not much point in worrying about it because it cannot be hedged.
