Inflation-Protected Investments
Inflation is like rust. It corrodes the value of your investment over time and therefore it is right for investors to worry about the rising inflation. The article provides a picture of the relationship between your investments and inflation and how best you can make the most out of the current situation
At its last policy meeting, the US Federal Reserve unexpectedly raised its expectations for inflation this year and even brought forward the timeframe on when it will next raise interest rates. The so-called dot plot of individual member expectations pointed to two hikes in 2023. This move has rattled the equity market. A couple of months back also we saw US bond yields inching up and the global equity market going down. It is widely accepted that a loose monetary policy along with higher fiscal spending and higher pent-up demand has stoked inflation globally. Conventional wisdom says that higher inflation is negative for stocks because it increases the cost of production or service due to rising input cost.
Besides, it also reduces the expectations of earnings growth, putting downward pressure on stock prices. Moreover rising inflation also leads to rising interest rate. While valuing the future cash flows from equity, higher interest rate will lead to lower valuation of equity. The graph below shows the relation between inflation (CPI) and Nifty PE. It is clearly visible that as inflation increases, the valuation of the equity market measured by PE declines.
Therefore, if everything remains constant, rising inflation will reduce the value of your equity portfolio. Therefore, inflation is like rust: it corrodes the value of your investment over time and therefore it is right for investors to worry about the rising inflation. The central fact of the global economy and even for Indian economy is that demand for all sorts of goods and services has surged recently. But supplies are not coming back with the same pace and matching the demand; therefore we are seeing prices of everything increasing. This is reflected in the consumer price index and the wholesale price index both of which measure the inflation at consumer and producer level, respectively. The wholesale price-based inflation hit an all-time high of 12.49 per cent in May 2021 on the back of a rise in prices of manufactured products, crude petroleum and mineral oils.
Similarly, the consumer price index-based inflation (CPI) for the same month came in at 6.30 per cent, much higher than the previous month of 4.23 per cent, and beyond the central bank’s inflation targeting range of 4 per cent plus or minus 2 per cent. It has crossed 6 per cent for the first time since November 2020. The more sticky and stable core CPI inflation rose to an 83-month high of 6.6 per cent in May 2021, and is expected to remain above 5 per cent throughout the fiscal year.
Historically, we have seen there is negative correlation between inflation and equity market return. The graph below shows the monthly return of Nifty 50 (rebased to 1) and inflation (CPI) since the start of year 2012.
On the surface it seems that whenever there is rise in inflation represented by CPI, Nifty 500 falls and gives negative return. Nevertheless, the relation between equity returns and inflation is not that simple.
Good, Bad and Ugly Inflation
The theory suggests that the price rise across the economy equally for different goods is good for a company and equity shareholders as a company earns more by passing on the higher cost to consumers and helps them to generate higher cash flows. Nevertheless, not all the sectors are impacted evenly. This means that some sectors’ revenues and costs are likely to rise by different amounts, and in turn, higher profitability will be skewed towards those companies whose input prices are not much impacted by the inflation, while being able to demand higher prices for their final goods.
Besides, what we have also observed historically is that inflation is good when we are coming out of very low inflation rate or if inflation remains within the RBI limit of 4-6 per cent. For example, the years 2018 and 2019 were of low inflation with average monthly inflation of 3.6 per cent. So when it started an uptick in year 2020, we saw very good return from equity. Nevertheless, in 2018 and 2019 the broader market did not perform well when inflation was low. Therefore, every rise in inflation is not bad for the equity market and similarly lower inflation is also not good for equity returns.'
The graph alongside shows the relation between inflation and monthly returns of Nifty 500 since the start of year 2012. It clearly shows that neither lower inflation nor extremely higher inflation is good for equity returns. Therefore, lower inflation is bad for equity returns; moderate inflation is good for the equity market while the higher inflation is ugly for equity returns.
Asset Classes Offering Shelter Against Rising Inflation
Considering different degrees of inflation impacting different sectors, companies and asset classes differently, we will try to find such sectors and asset classes that get benefited from higher inflation. This we will do by looking back on some previous inflationary periods that will help shed some light on which asset classes have performed best as inflation hedges. Before we begin, be sure to thoroughly investigate any fund you may be considering from this list to better understand how fully exposed it is to the inflation hedge you are looking for.
Commodities Fund
As we have seen earlier, sustained rise in price level is beneficial for some sectors, especially those in the commodity business. With the exception of year 2013, whenever there is higher inflation, commodity-related stocks do better. The graph below shows the relation between yearly return generated by Nifty Commodity TRI against average yearly inflation measured by CPI. Whenever there is increase in inflation, commodity-related companies perform well on the bourses.
One of the best examples of how rising inflation is beneficial for commodity companies is ICICI Prudential Commodities Fund. This is a thematic fund and as per its mandate, it invests at least 80 per cent of its corpus in the shares of company in commodity sectors. The fund’s current portfolio is heavily tilted towards metal and has generated returns in triple digits in the last one year. Besides, there is another fund, SBI Magnum Comma Fund, which is based on commodity and has generated return of 84 per cent in the last one year.
It has been observed that commodities have a more consistent record as inflation hedges as compared to many other asset classes because the consumer price index is partly based on commodity prices. Hence, it’s no wonder that commodity prices tend to move in the same direction as inflation. Hence, any fund that has larger exposure to commodities’ companies can be a good bet against rising inflation. The energy sector, which includes oil and gas companies, can be considered as another category that has shown a consistency in beating inflation. This is fairly intuitive as revenues of energy stocks are naturally tied to energy prices, a key component of inflation indices. So, by definition, generally these companies have performed well when inflation rises.
In India we do not have any thematic fund that invests only in energy companies; however, there are 13 equity-dedicated MFs that invest majorly in energy companies. These funds on an average have generated return in double digits in the last three months compared to 5 per cent generated by Nifty 50. They are mostly from the PSU theme as most of the energy companies such as ONGC, GAIL, BPCL, HPCL, Coal India, etc. are state-owned companies.
Funds With Major Exposure To Energy Sector
Nevertheless, before making any move or adding commodity fund to your portfolio as an inflation hedge, you should understand that these funds also show higher degree of volatility and larger drawdowns. Hence, only a high risk investor can consider this fund.
Value Funds
We are already seeing that in the last couple of quarters, value stocks have emerged as the new momentum stocks. The Nifty 500 Value 50 index, which consists of 50 companies from its parent Nifty 500 index, selected based on their ‘value’ scores based on earnings to price ratio (EP), book value to price ratio (BP), sales to price ratio (SP) and dividend yield, has returned 39 per cent year-to-date as of June 21. The broader gain in value stocks outpaced the 17.15 per cent year-to-date rise for the full Nifty 500 index and 7.01 per cent rise in the Nifty 50 growth index, which includes companies such as HDFC Bank, Hero Moto Corp, among others.
One of the other reasons why value stocks are rising is because of their underperformance for about a decade. Besides, value stocks do better and grow during an inflationary environment as the present income and strong cash flows become more important rather than the cash flow that will be generated in some distant future. There are 19 MF schemes with ‘value’ category. The average returned offered by them in the last one year is around 70 per cent and top the chart is IDFC Sterling Value Fund that has generated return in excess of 100 per cent.
Value-themed funds are anyways good for long-term investors. They may go through their bout of underperformance; however, when they come, they help you to cover the lost ground and cover little more. Most of the funds listed above were underperforming in the last few years but in the last one year they generated return of 68 per cent, which is way better than 53 per cent generated by Nifty 50 in the same duration.
Many consider gold also as a good hedge against inflation. Nevertheless, what we have seen is that gold has low correlation with equity and debt as an asset class and works better when there is sudden fall in the market or at the time of uncertainties. This is the reason we saw gold in Indian rupee touching a new high last year amid the fear of the pandemic and crash in the equity market. In 2020, gold funds and ETFs in India on an average generated return of 26 per cent. Real estate is another asset class that gives better protection to rising inflation; however, in India we do not have any such funds that have large exposure to this category
"The arithmetic makes it plain that inflation is a far more devastating tax than anything that has been enacted by our legislatures. The inflation tax has a fantastic ability to simply consume capital"
-Warren Buffett
Debt Funds
Rising inflation does not bode well for debt funds. Longer the duration of the debt funds, higher the interest rate associated with them. Hence, you should not be tempted by their last one year return and your focus should shift towards short and medium-term debt funds. Hence, short and medium-term debt funds are preferable if one wants to beat interest rate risks under the current rising inflation and expected increase of interest rate. Depending on your risk appetite and investment horizon, you should choose debt funds. If you are a conservative investor, invest in funds with duration of less than one year such as ultra-short duration fund, low-duration funds and money market funds. Investor with moderate risk can go for corporate bond funds. Investors who have longer investment horizon and have little risk appetite can invest in short-duration and medium-duration funds. Dynamic bond fund is also an option for such investors.
Inflation is Inevitable
Many economists and analysts believe that the current inflation is transitory in nature and may subside in due course. The consumer demand may not sustain given the job and income losses in the broader economy. This may be true for a developed economy; however, for emerging economies, inflation is more dependent on supply side factors than on demand. Therefore, we may see the current inflation phase to be sustainable. It may sound jargonised, but during higher inflation invest in securities that behave more like a ‘short-duration’ asset such as ‘value’ funds and avoid the growth business that acts as a ‘long-duration’ one. This is because in an inflationary environment, money now is worth more than money further down the line. Therefore, it is the right time to reposition your portfolio to protect it from rising inflation. Do not forget the quote from Venita Van Caspel, a famous American author: “Inflation takes from the ignorant and gives to the well-informed.