Get ready for higher interest rates | Economic Times

When the economy slows down, central banks respond by reducing interest rates. This, along with fiscal stimulus, can possibly arrest the slowdown and initiate a recovery. But as the recovery gains traction, it fuels inflation, first in asset prices and then gradually in consumer prices, which compels central banks to raise interest rates again.The Reserve Bank of India (RBI) has kept the rates unchanged for now. But with inflation on the rise once again, it appears a hike is imminent. Gradual increases in rates have a modest impact on asset prices. But the coming rise in rates might be steeper and more persistent.Downturn upon downturn, easing upon easingCyclical monetary easing is normally preceded by monetary tightening. However, the most recent global monetary easing (starting March 2020) was preceded by yet another period of easing. Hence, the next round of tightening might need to be severe and long-drawn so as to correct deep-rooted investor and consumer habits. For the first time in decades interest rates in major economies have been cut to such low levels. These low levels are not sustainable and interest rates are ripe for an upward correction.Usually, monetary easing occurs in different countries at slightly different times, in line with variations in economic conditions across those countries. However, this time, monetary policy was eased across the globe at the same time since the causal event (outbreak of covid) was common. Therefore, different countries are likely to face inflationary pressures, and increase interest rates, at around the same time. Reallocation of investments between asset classes is likely to be unidirectional across the globe and the possibility of domestic flows moderating international flows or vice-versa is low.US bond yields are rising nowThe 10-year bond yield had fallen to 0.6% in March 2020. 83257424Bottomed out yet?In India, the 10-year bond yield is at a multi-year low. 83257440What should investors do?Rising interest rates will impact different asset classes differently. Long duration fixed income securities will be the worst hit. For example, if interest rates rise from 6% to 8%, the 10-year government bond will depreciate by around 16%. Therefore, investors should consider moving away from long-term fixed income securities (govt bonds, corporate bonds, REITs or mutual funds that invest in these).Investors with a low appetite for risk could reallocate funds to short-term debt funds, liquid schemes or arbitrage funds. While those will give negligible real returns, they will protect against capital loss. I would not recommend withdrawing money from fixed deposits, because penalties on foreclosures whittle the benefits from superior future returns. But further investment in bank deposits is not recommended since real, post-tax returns are likely to be poor.On the other hand, PPF interest is tax-exempt and would be a worthwhile investment. But investments in the Provident Fund beyond the tax-free limit could be stopped. Its post-tax returns would barely cover inflation or even run short of inflation. If you are contributing to NPS, you should deploy the bulk of your contribution in equity funds. NPS is a long-term investment and returns in equity tend to be relatively stable and high in the long term.Investors with a higher risk appetite should consider investing in the following:Real estate could provide positive returns in an inflationary economy, especially if part-funded by fixed-rate debt. It may be difficult to get a 20-year fixed-rate loan. However, even if the loan rate is fixed for just a couple of initial years, that would provide substantial protection. Young couples who have been deferring their decision to buy might want to make their first purchases now. The pleasure of staying in a comfortable, self-owned house adds to the other advantages of a good investment.Commodities too might do well, though I am not bullish on gold. Gold is a hedge against inflation and equally a safe haven in times of economic distress. The economic distress caused by covid would eventually recede, which would have a bearish impact on gold prices. An alternative play on commodities could be in commodity stocks. This must be done with care because booms in commodity prices often end in sharp declines. Any investment will have to be carefully monitored and covered by a strong exit strategy. And it would need to be backed by strong research.Equities will be a mixed bag (as always!). Prudent investors would be best advised to avoid companies with capital-intensive businesses and/or high leverage. Investments in strong IT, pharma and consumer companies (all low capital businesses) is advisable right now. The IT sector is riding a multi-year positive demand trend that is unlikely to reverse soon. IT businesses have asset-light models and generate large free cash flows. A recent correction in IT share prices offers a ‘first time in a year’ opportunity for entry.Although the delay in Indian vaccine production is concerning, this is a temporary setback, and the India pharma story remains intact. Investments in pharma shares, at appropriate valuation, could yield adequate returns, even in a capital scarce environment. And if you do not have the inclination to dabble in direct equity and yet want exposure, there are several pharma-focused mutual funds to choose from. Market-leading consumer companies with strong brands will be well placed in a high inflation environment. Their products are, usually, ‘necessities’, and demand is unlikely to be impacted by rising interest rates. Additionally, market leaders are better protected against cost inflation --brand loyalty helps them pass increased costs on to their consumers.Has the time come?It is important to sometimes reallocate funds within your portfolio. It is even more important to do so at the right time. How do we know when the time is right ? What is a good lead indicator?Firstly, investors should be watching the monthly consumer price and wholesale price indices as well as the 10-year government bond yield. Since a single monthly reading may not fully capture a long-term trend, look at the 3-month and 1-year moving averages. Historically, a more than 0.75% increase in the 10-year bond yield (from its long-term low) indicates an uptrend.A more urgent indicator is the rupee-dollar exchange rate. A sharp decline in the value of the rupee would indicate that capital is moving out of India, which could force the RBI to increase interest rates to entice capital to stay. If exposed to long duration fixed income exposure, you might want to act before the RBI does that.(The writer is a former banker and now works as a consultant.)