Rising inflation and your portfolio

It is a well-established fact that inflation is crucial to investing, as it reduces the value of investment returns. Broadly speaking, inflation affects all aspects of the economy. From the investors’ point of view, the most challenging aspect in a higher inflation scenario is to keep up with the rate of inflation, in order to protect the value of the investment as well as the returns earned on it. Indian investors have been facing this challenge for some time now.

Before we analyse how investment portfolios get impacted, let us take a look at what the RBI has been doing to tackle this menace. As headline inflation continues to be above its comfort level, the RBI raised repo rates – the short term lending rates – by 0.50% on July 26, 2011, taking it to 8%. The reverse repo rate – the short term borrowing rate – has now moved up from 6.5% to 7%. The RBI has also revised its inflation target from 6% to 7% for the fiscal-end. It has, however, retained the growth projection for the current fiscal at 8%. As a hike in repo rates increases the lending cost of banks, all loans are likely to become costlier.

Undoubtedly, these are challenging times for investors. The impact of a higher inflation scenario on an investor’s portfolio would depend upon the composition of his/her portfolio. For example, for a portfolio that has a substantial exposure to equity, the immediate impact would be in the form of a falling portfolio valuation, as rising interest rates spell trouble for corporate earnings as well as the stock market. While in the long run, corporate earnings are generally able to outpace inflation, in the short term, investors get discouraged about continuing to invest in equities.

It is quite common to see even the most seasoned investors dumping their carefully-developed investment strategies and abandoning equity markets. Equity investors need to realise that although stock prices get impacted in such a scenario, the long-term potential of equity as an asset class remains intact. In fact, such uncertain times generally provide great investment opportunities to long-term investors to invest at attractive valuations. At the same time, it would not be prudent to invest aggressively just to make a quick buck in the short term. However attractive the valuations may appear, investing for the short term can always be a risky proposition. So, long-term investors investing in equities with a disciplined approach should continue doing so. In fact, these uncertain times benefit regular investors by way of ‘averaging’.

Investors who have a substantial investment in debt and debt-related options have their own share of opportunities and worries. On one hand, investment options such as fixed deposits, Non-convertible Debentures (NCDs), Fixed Maturity Plans (FMPs) of mutual funds as well as other options such as ultra-short term debt funds and short term debt funds provide attractive returns. On the other hand, due to an inverse relationship between interest rates and bond prices, options such as medium and long-term debt funds and gilt funds provide poor returns. Hence, it is absolutely critical to realign your portfolio in line with the emerging interest rate scenario.

Even for those debt options which provide higher returns, the real rate of returns, i.e. returns minus inflation, tends to be very low. This is the reason why tax-paying investors need to focus on tax-efficient options. Mutual Fund products, such as FMPs and short term and ultra-short term debt funds, can prove to be a better bet. For debt fund investors, any capital gains earned from an investment held for one year or more is taxed at a flat rate of 10% (without indexation).  Of course, the key is to select options depending on one’s time horizon.