DROUGHT-PROOF YOUR PORTFOLIO

By studying the four major droughts of the last 40 years,economist Sonal Varma of Nomura Securities has tried to assess how the drought will affect the economy.

Decline in food production. On an average,food production declines by 11.2 per cent year-on-year y-on-y. Kharif output on the average declines 14 per cent y-on-y and rabi output by 8 per cent.

Lower demand for consumer non-durables. Rural demand for consumer non-durables such as food,beverages and tobacco gets hit sharply. Demand for durables such as clothing,furniture,and personal care items also gets affected. But the demand for services such as healthcare,power and fuel remains largely unaffected.

Fall in GDP growth. On an average agriculture growth contracts 6.7 per cent y-on-y and GDP growth comes down by 1.7 percentage points. But this time the impact on GDP growth may be lower as the share of agriculture in GDP has come down from 44 per cent in 1970 to 17 per cent in 2008.

Rise in inflation. Droughts drive up inflation due to higher food prices. Not only in the year of the drought,inflation rises sharply even in the following year. Thats because the government tries to temper the price rise in the drought year by selling its buffer stock in the market,and so has less stock to fight the price rise next year. Uncertainty about the new harvest also drives up inflation. See table: Average historical impact of drought.

The case this year. Varma has revised Nomuras GDP forecast for FY10 from 6.3 per cent earlier to 5.5 per cent. While agriculture growth will slow down,she expects a rebound in non-agriculture growth. The 7.8 per cent growth in industrial output in June,if it sustains,could act as a counter-balance. Moreover,this year the decline in rural income due to the drought may not be as drastic. NREGA the governments rural employment guarantee scheme,high government spending on rural infrastructure,high minimum support prices of food grains in the last few years,and diversification by farmers into higher-value products are factors that are expected to cushion the droughts impact.

The policy response. With the government engaging in drought-related spending,any hope that the fiscal deficit would be lower than the Budget estimate of 6.8 per cent disappears. This would in turn exert upward pressure on interest rates. Varma also expects the central bank to allow the rupee to appreciate in order to curtail imported inflation she expects the rupee to move from around 48 currently to 44 vis-à-vis the dollar by March 2010.

As for monetary policy,while it is acknowledged that interest rates are a blunt tool for tackling supply-side inflation,the RBI has said in the past that in a situation of high liquidity,even supply-side inflation can lead to inflationary expectations getting entrenched,thereby resulting in wage-price spirals. While Varmas earlier expectation was that the first repo/reverse repo rate hike would take place in January,in case of a severe drought she expects the RBI to postpone it by a quarter. But once begun,she expects the RBI to hike rates at a faster pace.

How does this affect your financial planning?

Its clear that we will have to contend with high inflation this year and the next,and beginning some time next year,interest rates are likely to head up.

Impact on equities

When interest rates head north,they affect corporate profitability,and hence the return from equities,adversely. So investors could respond to a rising rate scenario by reducing their exposure to equities. However,bear in mind that inflation is also headed upward. Over the long-term,only assets like equities and real estate can help you beat inflation. Therefore,financial planners suggest that you either pare your equity exposure by a small amount say,5 percentage points,or merely undertake sectoral rotation. Besides,as Ashish Kapur,chief executive officer of New Delhi-based Invest Shoppe India suggests,The decline in the prices of shares with a high rural exposure over the last couple of weeks would anyway have pared your exposure,so selling might not be called for. Just postpone your buying in these sectors. If,however,you had a portfolio that was overweight on sectors dependent on rural demand,then certainly a realignment is called for.

Sectors likely to be affected. Most FMCG companies are expected to see an impact. According to Veer Sardesai,a Pune-based financial planner,The bigger FMCG players with renowned brands tend to be affected more when rural incomes are hit. Rural consumers shift from well-known brands to either smaller brands or to unbranded products. Players like HUL,ITC,Marico and Colgate could be affected.

Two-wheeler manufacturers like Hero Honda and Bajaj are likely to see an impact,as would tractor manufacturers like Mahindra and Mahindra and Punjab Tractors. Pesticide manufacturer Rallis India and pumping set manufacturer Honda Siel are also likely to witness a slowdown in growth.

With interest rates set to rise,investors would also need to pare their exposure to interest-rate sensitive sectors like automobiles and banks. According to Kapur,if earlier you had an 8 per cent exposure to the automobile sector,reduce it to six per cent; if earlier 15 per cent of your portfolio consisted of bank stocks,reduce it to 10 per cent.

If you pare your exposure to the above sectors,then which sectors should you move to? Infrastructure,IT and telecom appear to be good prospects.

According to Sardesai,Passive investors holding a diversified portfolio of stocks either through an index fund or an exchange traded fund should not worry and should continue with their investments.

Debt strategy

With interest rates headed upward,long-term debt funds will see erosion in their net asset values NAVs,as will non-convertible debentures NCDs. Reduce your exposure to them and move to shorter-term debt funds and floating-rate funds. If you are investing in bonds or fixed deposits,invest for the short-term so that you can catch the benefit of higher interest rates a year or so later. Any bond that you are holding currently should either be divested right away before rates start moving up or held till maturity . Continue with your investments in instruments like PPF.

Gold inflation fighter

To fight inflation,Vishal Dhawan,a Mumbai-based financial planner,suggests moving into real assets such as gold and real estate. If you decide to lower your exposure to equities say,by five percentage points,then you could increase your holding of gold by a similar amount. He normally suggests a 10 per cent exposure to gold to his clients; in these circumstances,he suggests that gold constitute 15 per cent of your portfolio.

Buy real estate

In India,there is no easy and low-ticket route for investing in real estate,such as through real estate investment trusts REITs and real estate mutual funds. If you have the funds,invest in residential real estate. Prices are down currently compared to their 2007 highs and interest rates are also close to the bottom. If you decide to take a loan,Sardesai suggests a fixed-rate loan without the reset clause. Though the interest rate on such a loan is high,you get complete peace of mind for the entire tenure. But if these rates are too high for your liking,go with Dhawans suggestion and opt for the type of loan that fixes the interest rate at a concessional level for the first three to five years and then shifts you to a floating- or fixed-rate loan at the rates prevailing then. Dont under any circumstance let the drought wither your portfolio.

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