The relationship between inflation and investment is quite old. Inflation is better known as the thief of purchasing power as it reduces your ability to buy goods and services. Inflation also means that Rs.100 that you receive after 1 year is going to be worth much less today. Consider the table below..
Value of Rs.100 receivable after 1 year under different inflation assumptionsDetailsInflation 4%Inflation 6%Inflation 8%Inflation 10%Inflation 12%Corpus after 1 yearsRs.100Rs.100Rs.100Rs.100Rs.100Inflation Factor1.041.061.081.101.12Present ValueRs.96.15Rs.94.34Rs.92.59Rs.90.91Rs.89.29
As can be seen quite clearly from the above table, the value of Rs.100 in today’s value terms keeps diminishing as the rate of inflation rises. Let us understand two things about the relationship between inflation and investment. The impact of inflation on investment decision works differently in case of debt and in case of equities as we will see later. Within this gamut let us look at the best investment options and plans in India when inflation is above 5%. But first, why is inflation likely to be high in India?
Why inflation is likely to be high in India?
Source: MOSPI and Trading Economics
As can be seen from the above chart, the consumer inflation (which typically drives interest rates) has shown a sharp rise of nearly 470 basis points since June 2017 before tapering slightly in the last couple of months. This sharp rise in inflation has been driven by 3 factors. Firstly, the Kharif output in 2017 suffered due to erratic rains and the actual output was below the levels touched in 2016. This created sustained food inflation since June last year. Secondly, crude oil plays a key role in creating secondary inflation as oil has strong externalities and impacts inflation in a variety of ways across products. This has also been instrumental in keep inflation at elevated levels. Thirdly, with the government assuring MSP to Kharif farmers at 1.50 times their cost of production, the food inflation is likely to stay higher through the current year. While the RBI comfort level on inflation is below 4%, the actual inflation could be closer to the 5% mark. So, what exactly should be your investment strategy under these circumstances of high inflation?
An investment strategy when inflation remains above 5%..
The interest thing to note is that equities normally perform well in times of rising inflation. That is because higher consumer inflation leads to higher producer inflation and that means pricing power comes back to the manufacturing sector. Historically, equities have not only been a hedge against inflation but equity indices have done well when inflation is at slightly higher levels. Of course, we are not talking of runaway inflation because that destroys value across the board. Equity mutual funds with the support of professional management could be a good choice.
It may sound ironic but dividend yield stocks may be a good bet in a high inflation scenario. You can argue that higher inflation means that you get lower dividends in real terms. That is true but we are looking at stocks that will hold value. For high dividend yield stocks their dividend value acts as a support below which the price normally does not fall. In fact, any dip leads to value buying and you can take advantage of that.
Try your hand at global ETFs, they can offer inflation protection. If India is having inflation then you can look at other economies with lower inflation. Today mutual funds offer ETFs that benchmarked to global markets through ETFs. This will not only diversify your India risk but give you an asset class that is not contingent on the level of inflation in India.
Inflation indexed bonds and variable rate bonds could be a good choice for debt investors. In times of high inflation don’t get tied down to fixed return bonds with long maturities. That is bad debt strategy. Such bonds will see more price depreciation because higher inflation raises the prospects of a rise in bond yields. Variable rate bonds or Inflation Indexed bonds will see the yields go up with the market scenario and that means price damage will be very limited. You can try that out for debt.
Restructure your portfolio in favour of low debt companies. Of course, you can also be very selective about what equities you own in case you are into direct equities. For example, companies with high levels of debt more vulnerable to high inflation levels. Similarly, sectors like construction and auto which use commodities as inputs will see a rise in input costs and may not exactly be able to pass on these costs to the end consumer. Here again you need to be careful.
Commodity stocks could be a good bet. Yes, that is right! Normally commodities like metals, alloys, agri commodities, oil etc tend to benefit from higher inflation. As we said earlier higher inflation marks the return of pricing power to producers and commodity companies can make the best of that. You can align your equity trading portfolio and even your mutual funds investment portfolio more on those lines.
The bottom-line is that you still have a variety of options to pick and choose from the investment gamut if you want to