With some indications of interest rates peaking, it is time to review your investment strategy
There is a heated debate among analysts going on about peaking of interest rates here. Looking at the moderating growth numbers and the length of the rate hike cycle, some analysts are of the opinion that interest rates are peaking, and they will slow down in the coming months. They feel the Reserve Bank of India (RBI) has already achieved what it set out to do - moderate growth and inflation.
On the other hand, those analysts focusing on the inflation numbers are doubtful about this. They are of the opinion that there may be some steam left in the rate hike cycle, and they may peak at the end of this year or even a little later. However, there is a broad consensus among analysts that the rate hike cycle is closer to its peak. This information is important to investors as the higher interest rates seen at the peak of the interest rate cycle signal a shift in investing - away from stocks and into fixed income securities.
Since fixed income securities' prices move contrary to interest rates, the best time to invest in these securities is at the peak of an inflation cycle, when interest rates are high and fixed income securities trade at low prices. Such opportunities are likely to occur periodically every few years, due to the limitations that central banks face when trying to curb inflation with a tight monetary policy. India is facing such a situation now as the country has undergone a series of rate hikes in an effort to curb inflation. Today, a fixed income investor is probably getting more returns risk free than a stocks investor who has undertaken more risk and is getting lower returns.
This is due to the fact that interest rates play an important role in the performance of the stock markets. Higher interest rates imply that companies must pay more on their borrowings for capital investments. This naturally impacts their margins negatively, thereby bringing down stock prices. At the peak of an inflation cycle, stock prices are high compared to their forward earnings. Their returns and yields compare unfavourably with the high yields at virtually no risk available from fixed income securities.
In a rising inflation period, a typical interest rate cycle consists of two stages - a series of rate hikes, followed by a period of stabilisation. When the inflation rate rises due to demand pull pressures, the RBI will hike the interest rates to fight off inflation and cool down the economy. As the effect starts, with the economy slowing down, the interest rates will be held steady for a while. However, if the inflation rate is more due to a cost push effect, resulting from sharp increases in the fuel prices for example, rather than demand pull pressures, the rate hike cycle can continue for a longer duration.
Investment strategy
By understanding how an interest rate cycle works, an investor can put in place an investment strategy that works differently at each stage of the interest rate cycle. As the interest rate cycle nears its peak, a risk averse investor can allocate a larger part of his portfolio to long-term fixed income funds, which will benefit from the stabilisation and subsequent fall in interest rates.
But, till the peak is reached, he must invest in shorter duration bonds and fixed deposits to take advantage of the rising interest rates. That said, just how an investor will determine when the peak in the cycle occurs is a question that does not have an easy answer.
For a stock only, risk-embracing investor, tagging the investment style to interest rates basically means investing in different industries at different stages of the cycle. Foreseeing that interest rate is going to increase, an investor will tend to shy away from interest rate-sensitive sectors such as banking and auto, knowing that these industries will be hit during rate hikes. As the rate hike peaks, the sectors that come back into focus are cyclicals, materials and basic industries.
Hence, investors with a high risk appetite, at the current juncture, should look for signs of peaking in the interest rates and get ready for some sector rotation.
