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Negative Interest Rates: Implications for Asset Allocation

 

Jul 2016

We must confess that prognosticating about future asset returns globally in a presumably low return world has become very difficult due to the market numbing sanitizing action of the central banks. Our fear is that we will misinterpret market signals and at some point of time find ourselves exposed in the most humiliating of ways.

 

Interest rates are plunging to all-time lows in the developed world with close to $12 trillion of negative yielding debt. It seems to us that we have managed to create a black hole of negative rates which is slowly and steadily devouring all the good collateral. Add to it the referendum of doling out monthly checks in Switzerland, mythical arrows of economic impotency in Japan, populist revolt in Europe and United States, exploding pensions deficits, welfare spending, human labor replacing automation, uneconomic migration and all sorts of exits in the work, it stands to reason that it will be a messy outcome. As far as Indian debt is concerned, we think it is in the midst of a secular bull market and is likely to provide far better and stable return than other asset classes. Fixed rate deposits will become a thing of the past with banks already reluctant to provide long term options. Given that the pension liabilities will increase far faster and bigger in India, holding quality longest maturity debt is the best asset class to be in. Credit is underpriced so it is better to stick to shorter term credit with maturity of 1 year or less.

 

Equities stand at a critical juncture. We have not been shy in calling developed market equities overpriced with falling profit margins, financially engineered buybacks and the slowing momentum. But, the falling interest rates do bring about an interesting dilemma – classic equity valuation using discounted cash flow model does yield every increasing price multiples. So, in a land of tough choices, we would stick to where the future of the world lies and that is democratic emerging markets like India, Brazil and Australia where the powers of economic sanity still prevail. United States also makes the cut but not for reasons most people think. A Trump, if victorious, will unleash a fiscal expansion on the back of increased debt issuance. The likelihood of such an outcome is far greater than it appears.

 

This provides a nice segue to commodities – our favorite asset class at the moment. As we have said umpteen times, commodities have bottomed out and have an excellent risk to reward ratio for the next few years. Supply is now getting curtailed for most commodities following the end of Chinese super cycle and prices are in the process of turning up with gold leading the way. If United States unleashes fiscal stimulus over the next few years, it is going to provide tail wind not seen since early 2006. One part of the commodity complex we are not in love with is energy. The speed with which the world oil complex has changed, with United States becoming the lead producer, increased productivity and efficiency in oil and gas production, fracking, abundant coal as a backstop and new technologies in the work with revolutionary batteries and energy catchments is definitely not positive for energy prices. The better way to play energy would be investing in energy producers.

 

Finally, it brings us to the world of currencies. Dollar index is back to 96 after hitting a high of 100 followed by a low of 92. We are having a harder time hanging to the bearish dollar view and as such would move to neutral. As far as rupee is concerned, we think rupee will slowly depreciate but not by an amount dictated by interest rate differentials. This may make the Indian rupee look stronger on real effective exchange rate risk but we believe it is more of a sign of tail risk in other currencies than in the Indian rupee.

 

If you were to ask us the ideal strategy for an investor, we would suggest a multi-asset, multi-strategy approach to alleviate the risks. On the asset front, allocate your capital to all the major asset classes – fixed income (40%), equities (30%) and commodities (30%). On the strategy front, allocate your money to both long only strategy (80%) and relative value strategy (20%). If you have need for foreign exchange, then hedge your exposure, else stick to local currency.

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