SENSEX and NIFTY 50 gained over 8% in the month. It’s the first time since August 2021 that the two indices have risen so prominently.
If you have stayed the course, the colour of your portfolio is probably all green. Even the mid-cap and small-cap indices joined the party, rising 11.7% and 8.9%, respectively. But if you got swayed by the panic and fear, August would have begun with regrets.
Of course, investors needed a lot of guts to stay calm in the past seven months. Markets have tested everybody’s nerves. But it may not be all gloom and doom hereon. At least, that’s what the data seems to suggest.
But before we discuss the silver lining around the dark clouds that have engulfed the markets, a little background.
The Perfect Storm: War, Inflation, and Interest Rates
Since the beginning of the year, whatever could go wrong, went wrong. First, it was the Russia-Ukraine war that broke out in February. As the markets priced in the impact of this development, we saw interest rate hikes across the globe.
Rising interest rates always decrease the attractiveness of investing in a risky asset class like equities. Investors flock to risk-free assets as they suddenly become good enough. Remember the forgotten FDs? Their interest rates have been slowly on the rise. For example, Bajaj Finance, India’s largest NBFC, offers as high as 7.5% p.a. interest on 44-month deposits. Seniors get a whopping 7.75% p.a.
It’s no coincidence Foreign Institutional Investors have pulled out $26 billion from Indian equities in the last six months as the US interest rates rose. Indian investors are also exhibiting a similar trend of not getting attracted to equities. As markets correct, the opening of new demat accounts and new investors signing up for mutual funds have slowed down in tandem, and so has the growth of SIP flows.
The Question On Everyone’s Mind: How Will Stock Market Move?
Given the July rebound and August follow-through, everyone has one question. Going forward, what will happen in the stock markets?
No one can predict the market with certainty. We won’t do that either. Let’s deconstruct the past and present to get clarity. To do that, we must first look at the reasons for volatility. It was the lack of clarity on three aspects.
- To what extent can interest rates rise?
- What will be the velocity of rate hikes?
- How long will central banks keep raising the rates?
We turn to history for cues. In the past 20 years, the highest yield on a 10-year G-Sec was 9.18% (July 2008). The current 10-year G-Sec yield is 7.2% or thereabouts, falling from the 7.49% in June this year.
Whether India breaches that historic high, nobody can predict. But one can say with certainty that it will depend on inflation, which will then determine the repo rates, which eventually will guide the G-Sec trajectory.
But we have seen similar situations before. Therefore, we analyzed the repo rate and G-Sec trends for the past 20 years and studied their correlation. Here’s what the data showed:
- On average, G-Sec tends to be 1.16 times of repo rate. The highest was 1.8 times, just a couple of months ago (April 2022). The second highest was 1.7 times in January, February, March, and May 2022. (Surprising that all the highs are in 2022, isn’t it?)
- At present, G-Secs are 1.5 times the repo rate.
- The spread between G-Sec and repo rate typically narrows as inflation gradually falls.
If you go by the recent data, inflation is already showing signs of peaking. RBI, too, sees the indications. Hence, we don’t reckon the probability of a significant rise in repo rate from the current levels unless inflation throws a surprise or the geopolitical situation worsens. There are expectations of a 25-50 bps hike in the upcoming monetary policy, which is largely factored in by markets.
The unknown is the US Fed. If the Fed maintains the pace of policy rate hikes, then RBI’s primary motive will be to continue the high speed of interest rate hikes. The focus would be to prevent excessive rupee depreciation, not inflation in isolation.
The good news: After increasing the policy rate by 75 basis points on July 27, the US Fed has signalled that the pace of further rate hikes may be moderate.
This is where the historical correlation between G-Sec and repo rate matters. Even if there is room for the repo rate to go up, the fixed income rates may not rise drastically, as reflected by the past G-sec and repo rate’s correlation.
At present, the spread is too wide and may narrow down, as has happened in the past. So, while interest rates may continue to rise, there is little room for them to rise unabated if history is a reliable guide (which we believe it is).
While the current volatility in equities has been primarily due to interest rates, there are other factors at play, which seem to be turning positive, too.
A Silver Lining For Equities?
Since its peak in October 2021, the SENSEX has seen a price correction of around 7%. But the valuations, as measured by SENSEX’s price to earnings, have corrected by a whopping 22.62%. This valuation correction has brought its trailing P/E ratio down to 22.85 as of June, which is slightly above its long-term average.
The Q1 earnings of India Inc. have shown mixed results so far, and business conditions will remain tight as interest rates are yet to peak. It indicates that runaway EPS growth looks unlikely. So, as an equity investor, the ride may be bumpy.
Also, it wouldn’t be wise to ignore fixed income as an asset class as rates are positive in real terms (returns after accounting for inflation).
Given the current trends, risks, valuations, history, and real interest rates getting positive, even long-term investors should adopt a balanced approach instead of 100% equity allocations. You can do so by following the asset allocation strategy, which can help tide the volatility.
Investors generate returns by staying put in the market, giving their investment time to compound. However, once you have skin in the game, it’s difficult to ignore the market movements and stay immune to daily noise. Tough times can play havoc on our emotions and make us greedy, fearful, risk-averse, or panicky. Asset allocation and asset rebalancing strategies can reduce the risk and optimize returns. This is precisely what ET Money Genius is built for.
Genius prepares an investment plan that relies on asset allocation as the primary way to manage risk & generate returns. The intelligence behind Genius caps each investment plan’s risk based on the Investor’s Personality. Each month, Genius generates the most appropriate Asset Allocation and alerts its member investors so that they can seamlessly rebalance their portfolios. Our endeavour is to ensure that the members of Genius encounter lesser surprises from Mr Market’s mood swings.
The approach reflects in the recommended equity allocation of our two higher-risk investment strategies of High Growth and Growth:
Markets are not about equities alone. They comprise debt and gold, too. Each of these asset classes performs at different times. Investment strategies based on asset allocation and periodic rebalancing protect your portfolios from bleeding extensively. Such investment strategies also reduce the volatility in your portfolio and create a favourable condition for you to “remain invested”.
All these factors ensure that you “give time” to your portfolio. This is when compounding happens, and you don’t miss out on the outsized gains we witnessed in July.
If you have already figured out how to give time to your investments, you are a Genius investor. So, stay Genius. If not, you must consider upgrading to Genius to benefit from its smart asset allocation and rebalancing strategies.