The US Federal Reserve’s second rate hike in three months, with a stated intention of more — albeit gradual — hikes ahead, has caused concern for investors. Future Fed hikes could potentially lead to flight of foreign capital from developing economies, squeezing liquidity and causing market volatility.
Where does this leave equity investors, who typically regard debt as a diversification tool?
To be sure, diversification protects one against the risks that accompany concentrated investment in a particular asset class. But, it works best when two asset classes have negative correlation, so that in the event of, say, a fall in the equity market due to some adverse event, the other asset class will buck the trend, or fall much less, thereby containing the downside for an investor.
As the table shows, in the developed markets, fixed-income instruments (bonds) offer negative correlation with equity, which makes them the ideal hedge.
However, an investing principle that works in one market need not always work in another. As table shows, the developing countries indicate a trend to the contrary.
Even in India, the 10-year government security — represented by the CRISIL 10-Year Gilt Index — and the BSE Sensex show positive correlation across timeframes.
What is causing this difference?
In India’s case, the policy design in recent years has been aimed at curbing inflation, which used to be persistently high. The central bank had to raise policy rates, which pushed up bond yields, resulting in negative bond returns (since bond prices and yields are negatively correlated). Rising policy rates tend to impact future earnings negatively by pushing up the borrowing costs, which in turn impacts equities negatively. This combination of falling equities and negative bond returns results in a positive equity-bond correlation.
In contrast, in developed countries, inflation has tended to be low and so rising inflation is seen as good (since it can stimulate job growth). This is why, in the US, when the Fed rate hike was being factored in for 2016, equities (S&P 500) rallied 11.24 per cent whereas debt (S&P US Treasury Bond Current 10-Year Index) fell 61 basis points, showing a negative equity-bond correlation.
Coming back to India, when inflation is in a comfortable range, policy rates may be lowered to support the growth of the economy. Such a scenario — growth expectations on uptick and interest rates trending lower — benefits both equities and debt, again making them positively correlated. This was observed in the pre-demonetisation period this fiscal when the BSE Sensex and the CRISIL 10 Year Gilt Index clocked 9.19 per cent and 8.15 per cent returns, respectively, given the Reserve Bank of India’s accommodative policy stance and efforts to maintain neutral liquidity conditions in the market. Interestingly, the correlation came off following demonetisation as the debt markets rallied on the back of a surge in bank deposits even as equities fell due to lower growth projections.
A good asset allocation mix, thus, becomes critical, bringing us to the old adage ‘don’t put all your eggs in one basket’ — or two. Fixed income investments are a great choice from the objective of steady income along with capital protection. However, just as a pure equity portfolio would be too risky, a pure debt portfolio can fail to meet the investor’s objectives. Also, although not negative like in developed countries, the positive correlation between debt and equity in India is low, which suggests debt, if not the best hedge, can still act as a diversifier. This
can be seen from the performance of the CRISIL-AMFI Balanced Fund Performance Index (index of debt-equity hybrid funds) which outperformed the CRISIL-AMFI Large Cap Fund Performance Index (index of pure equity funds) over multiple timeframes – both long and short. To diversify further, investments should go into other asset classes as well, such as gold (which offers low or negative correlation with equity) and real estate, etc, based on the risk-return profile of an investor.