The global economy is going through turbulent times as inflationary pressures have been hurting many economies. The rise in geopolitical tensions, mainly the Russia-Ukraine conflict, has led to supply chain breakages and has sent energy prices soaring, which is the principal contributing factor to rising global inflation. The worst may not be over for the global economy with Europe likely to face a harsh winter due to severe energy shortages. Money pumped into economies by central banks to tackle Covid-19 added to the inflationary pressures. Controlling rising prices has become a major concern for policymakers and central banks.
Many economies take the hit
As a result, the news flow is most often not good. Pressure is building not only in major economies such as the US or the United Kingdom but is widespread and also in less talked about geographies. The extent of the problem can be gauged by comparing the Indian scenario with that of Argentina. While the Indian central bank, the Reserve Bank of India, is grappling to control inflation which stood at just over 7 percent as of September 2022, in Argentina inflation is expected to touch a mind-numbing 100%. Argentina is not suffering alone, though the intensity might differ. Turkey, Iran, and the Netherlands are also experiencing double-digit inflation, a rare phenomenon for them.
In the UK, economic issues became so serious that it led to the Chancellor of the Exchequer, Mr. Kwasi Kwarteng, having to demit office abruptly. The Bank of England had to pledge to buy bonds on September 28, when pension funds saw their derivative book imploding due to a sudden rise in interest rates in a short period. Most market participants are aware that such intervention may not last long and bond prices may start to fall again.
Investing in an uncertain global economic scenario can be tough. Here we look at how various asset classes react in such a milieu.
Debt markets uncertainties
Interest rates in the economy are raised by Central Banks to cool down inflationary pressures in an overheated economy. Rising interest rates put pressure on bond prices. Bond prices fall as interest rates in the system move up. This, in turn, leads to higher bond yields. This is especially true in the case of long-term bonds. That means the portfolios holding long-term bonds see marked-to-market losses, which may pull down their portfolio valuation. Over the last year ended October 17, 2022, gilt funds with 10-year constant maturity lost around 0.69%. Gilt funds invest in government securities.
In the present rising interest rate scenario, most investors prefer to stay with short-term bonds, typically maturing in a year or two. Some savvy bond investors may want to start allocating small sums to long-term bonds to benefit from the high yield they are quoting at. Such investors may keep allocating capital to long-term bonds with a view that at some time in the next year the rates will peak. Such investors are willing to face short-term pain to make big money in the medium term. They typically have a view of a minimum of three years.
The trouble does not remain limited to bonds. It gradually affects other financial markets and subsequently those economies and their trade counterparts.
The currency cauldron
With the general economic scenarios becoming uncertain, investors generally avoid risk assets, such as equities, as they become increasingly volatile. When the risk-taking ability of capital goes down, the risk premium goes up. This risk-off tendency is resulting in money being pulled out of many markets and flowing back into the US. As a result the dollar index – a basket of six major currencies that are used to measure the strength of the US dollar, is going up relentlessly. Popularly known as DXY, the dollar index was quoted at 112 on October 18, compared to 93 a year ago. The rise indicates the strength gained by the dollar. The US dollar is widely expected to strengthen further as the uncertainty is unlikely to end soon.
Impact on India
In an intertwined global economy India cannot avoid the pressures. Along with all major currencies, the Indian rupee has weakened against the dollar. This may result in a higher current account deficit as India is a large importer of crude oil and gold. Global prices of both these commodities are fixed in US dollars and a strong dollar means India imports inflation. The price hike will invariably fuel inflation. The RBI would be left with no option but to continue raising interest rates further. It has already hiked interest rates by over 200 basis points since May 2022. This would in turn hurt the debt and equity markets.
Taking the equity risk
The stock markets across the globe have been volatile on the back of the series of interest rate hikes by central banks. Rising interest rates are used by central banks as a tool to slow down economies. This impacts sentiments in the stock markets resulting in equity prices being impacted negatively. Valuations of stocks come down, especially those linked to businesses that are considered as 'rate sensitive'.
Moreover, companies with weak fundamentals and poor cash flow generation capabilities tend to suffer in such times. Rate hike cycles may sometimes result in higher volatility in the stock market. This can cause panic among investors. During these times, investors often take recourse to fixed-income investing to ensure reduced portfolio volatility. However, investors who are selective in their stock picking and those who take a long-term view of equities could see substantial gains in their portfolio going forward. This is because over the longer-term equities generally help in riding out phases of economic downturn to provide inflation-beating returns.
Betting on gold
Gold is a much sought-after commodity in uncertain times. The yellow metal acts as a hedge against volatility for investors. Gold prices generally rise when there are geopolitical uncertainties. Historically, when other asset classes such as equities and debt come under pressure, investors quickly shift to safe-haven buying of gold. The investor interest pushes up the prices of the yellow metal.
In conclusion, during uncertain times such as the present one, experienced investors would be better placed if they have a diversified portfolio spread across asset classes and different geographies. This helps in minimizing concentration risk since different asset classes and different geographies may not perform similarly, thereby helping in capping the downside.
Team AltiFi.