Look ahead rather than looking behind
Portfolio positioning should always be forward looking. Your portfolio should reflect your expectations of the future. Unfortunately all portfolios have a big element of past returns in it and that’s where most portfolios go wrong. For example if equities have done well in the past, most portfolios are weighted towards equities and when equities go into a downturn, portfolios deliver below average returns. It works the other way round too when after a big equity correction portfolios become defensive and do not capture future potential gains in equities. The same is true with other asset classes as well, including bonds, commodities, real estate etc. In order to avoid this mistake of taking past returns to position portfolios for the future, we will do some crystal ball gazing to see where portfolios should be positioned.
The first housekeeping activity we will do in crystal ball gazing is place a cloak on the past. We’ll assume that we are first time investors looking to build portfolios for the future. The second step is to evaluate how macro economic conditions will pan out in the future. The next step is to take asset classes that are within our reach and easily accessible. Equity and fixed income are the obvious first choices given the ease of investments. Gold follows next given its outperformance in recent times. The outlook for the macro economy will judge the return potential of each asset class and then the portfolios will be built accordingly.
The Macro Economy
The two main determinants of how asset classes will behave down the line are GDP growth and inflation. One affects the other and the relationship is not always smooth. India is now going through a phase where inflation as measured by the WPI (Wholesale Price Index) is trending at close to double digit levels. High inflation is forcing the RBI to raise policy rates. RBI has raised policy rates by 300bps over the last one year to ward off inflationary pressures. High policy rates coupled with high inflation are clouding the outlook for economic growth. The question is how will growth and inflation pan out in the future?
The outlook for growth and inflation post 2011-12 is brighter. The reason is the efforts of the RBI and the government in containing inflationary pressures will bear fruit down the line. RBI has hiked rates while the government has consciously brought down its fiscal deficit. Fiscal deficit as a percentage of GDP has been brought down from 6.8% in 2009-10 to 4.6% in 2011-12. There may be slippages to the 4.6% deficit rate due to higher subsidies but the intent of the government is more important. The government is realising the folly of a borrow and spend policy in order to bring about economic growth. The recent events in the Eurozone where countries from Greece to Italy are facing debt issues has place the government on guard against its own debt levels. The downgrading of the US from AAA to AA+ negative by S&P and the subsequent chaos in markets where equity indices fell by over 10% in a week is another factor in opening the eyes of the government to high debt levels. A government that recognizes the importance of a sustainable level of finances is positive for the future course of the economy.
The fall in growth from 2010-11 to 2011-12 is causing pain for investors in equity. The rise in inflation is causing pain for investors in debt. Investors in gold have had a good run due to worries on debt and currencies. However going forward, you would have to look at where returns will come from rather than where returns came from over the last one year.
Why should equities and bond deliver returns while gold prices fall? The reason is that the policy actions of the government and central bank in improving government finances and bringing down inflation expectations will help bring down interest rates. Ten year bond yields currently trading at levels of 8.2% is likely to come off by at least 100bps as inflation come off and RBI cuts rates. A fall in interest rates will bring down cost of borrowing in the economy and this will benefit consumers as well as businesses. Nifty at 5200 levels can rise to levels of 6500 if interest rates come off, inflation goes down and government finances strengthen.
As always there is a risk in crystal ball gazing. The risk is that government does not bring down fiscal deficit and inflation remains sticky at higher levels due to food and commodity prices. Global economic growth if it weakens can also impact the economy. There could be a case of debt default by some governments or the US Dollar can turn into a very weak currency leading to chaos in global markets. In such cases gold will continue to outperform equities while bond yields may not come off on worries of government finances.
There is no return without risk. It is worth taking the risk of macro factors improving from present rather than bet on the other way round. Your portfolio should be weighted towards equities and bonds rather than gold or fixed deposits.