Flight To Safety: Funds to flow into fixed income, debt funds

The volatility and the lower returns stem from the fundamental reason that the level of inflation in most of the global economies touched very high levels. (Representative image)

Looking to the very short term, that is, about a year or so, there has been significant volatility in the equity markets. The end result of it is relatively lower returns or insignificant returns from equity investments. While in the immediate term it may continue to be so, it is bound to come back as the fundamentals realign to put the economy on a faster growth path. Meanwhile, there is a move globally into income-earning assets like fixed income during the interim period, when some of the affected asset classes could add to portfolios with an average or less than average return.

The volatility and the lower returns stem from the fundamental reason that the level of inflation in most of the global economies touched very high levels, fuelled by high oil prices and also elevated food prices. It is a fact of experience over the last five decades or more that in times of persistently high inflation, equity markets are not in a position to sustain rich valuations.

In the context of the US markets, the optimum inflation level has been placed at 3.50 percent based on historical data pertaining to equity valuations, and at any point in time when inflation soared and stayed high, it invited a substantial correction in the markets. This correction, it is to noted, is not just due to the phenomenon called inflation but primarily due to the consequences of sustained high prices for the economy and businesses.

Higher Cost Of Funds  

To combat high prices, the hard money policy pursued by all major central banks in the last two years, coupled with liquidity normalisation measures, resulted in receding market capitalisation, and also a higher cost of funds for those enterprises that required regular funding. With the cost of money gradually rising, the cost of carrying positions too becomes more expensive. In such situations, businesses that are not in a position to effectively pass on the rising input costs to consumers quite naturally face margin compression.

Effectively, in an economy like India, high prices directly impact rural demand as rural spending responds faster to changes in real income. Inflation pulls down spending power, and, thereby, dampens demand conditions. However, such conditions never last long. Once the first signs of a disinflationary trend set in, the interest rate scenario could start moderating, and the central bank's policies too could undergo changes. One of the active trades available to investors is to switch to the very short end of the yield curve and stay invested in liquid assets or funds. This will be helpful in two ways.

Managing Asset Allocation

One, the yield curve is inverted, and there are high short-term rates that could be captured for the portfolio. Two, as market conditions start improving, the funds could be easily switched into long-term investments, including equity investments. The switch idea can be easily executed in the case of malleable portfolios that have clear strategies in place. The switches may be possible in fixed income too, where it is possible to switch into a shorter maturity from the long-end, pick up yield, and also gain on duration. These trades could also be reversed as long-end yields saturate at a later date.

These are some of the ways in which the income-earning capacity of the portfolio can be enhanced in the immediate term. While such things may facilitate some inflows into fixed income, in the immediate term, the longer-term allocation between asset classes will be guided by the fundamental principles of asset allocation.

In the case of corporate investors, or even in the case of individual investors with dynamic risk profiling, the fundamental ratios of allocation will not undergo any changes over the long term. This is because the inflation-beating growth that equities provide and the security of a fixed stream of income have a trade-off that is well established beyond any canon or convention.

Joseph Thomas, Head of Research, Emkay Wealth Management. Views are personal, and do not represent the stand of this publication.