Invest In India

With higher inflation likely to erode a good portion of one’s returns, investors must consciously inflation-proof their portfolios. Here are a few pointers.
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It is a bit of a paradox that inflation data should point downward even as commodity prices are headed in the opposite direction. This is exactly what is happening in India today.

Not only are consumer prices well ahead of the official price indices, even the official inflation number is expected to climb over the next year. But why is inflation important, what does it mean to investors and how should they factor inflation into their financials plans? An analysis.

The two commonly used indicators to gauge inflation — Consumer Price Index (CPI) and Wholesale Price Index (WPI) — have historically moved in tandem. But not any longer. Growth in the WPI, after being in the negative zone for 13 weeks, has now barely turned positive, with a reading of 0.3 per cent for the week ended September 12, 2009.

But growth in the CPI-Industrial Workers is a whopping 11.8 per cent for the latest month (July 2009). (In this analysis, we refer to the CPI-Industrial Workers index as CPI, as that may be most representative for the urban consumer).

If as an investor, you took note of the official inflation numbers (the WPI) to conclude that inflation was at a low ebb, you would be mistaken, as it is the CPI that is more representative of the prices you pay.

Higher inflation in consumer prices

In fact, such a divergence between the CPI and the WPI is of fairly recent origin. Between 1998 and 2008, inflation measured by the two indices moved in much the same way, with the correlation between them at a near perfect 0.99. However, that completely changed in the last year, with the correlation slipping to a negative (-0.14), suggesting that the CPI has moved up even as the WPI corrected sharply.

The reason for the divergence is explained, to a large extent, by the higher weight assigned to food articles and a lower one to fuel prices in the CPI. Food and food products form 46-67 per cent of the CPI, against 25.4 per cent in the WPI indices. On the other hand, fuel and other energy products have weights of 14.2 per cent in the WPI against 6.43 per cent in the CPI.

A rising CPI may also indicate that the services you consume are getting more expensive, as it takes into account expenses on housing (15 per cent weight) and services such as health, education, telecommunications and transportation, which are ignored by the WPI.

In the first half of 2008-09, WPI inflation ruled higher than CPI due to higher prices of oil, manufacturing products and metals putting upward pressure on the index. As oil prices and prices of other commodities (metals and minerals) cooled off, WPI began to fall; simultaneously, supply constraints started showing up and the CPI began to tread higher ground, outpacing the WPI.
What it means for investors

Having noted the divergence between CPI inflation and the official inflation numbers, what are the implications for investors?

Lower real returns: CPI inflation at 11.8 per cent, implies that investors who ploughed their savings into an 8.5 per cent one-year deposit offered by a public sector bank in July last year, would have ended up with a negative 3.4 per cent real return. The annual rate of CPI inflation in the last five years was 7.3 per cent.

This implies that any fixed income option that delivered less than 7.3 per cent has been fetching the investor a negative return in real terms. Note that inflation erodes your real returns from fixed-income investments. In a savings-focussed country such as India, where much of the savings are ploughed into bank deposits, higher inflation may effectively erode a good portion of the investors’ returns and, at times, the principal as well.

Therefore, investors who put their money mainly into fixed income investments have to make a conscious attempt to seek out those that offer high double-digit returns. Or they should add riskier investments to beat inflation.

Factoring inflation into your long-t erm plans: Financial planners usually assume a 5 per cent inflation rate (based on the WPI) to compute targets for long-term financial goals in Indian context. But the recent CPI-WPI divergence suggests that they should actually be assuming a much higher number.

As mentioned above, CPI in India over the last five years has grown by nearly 7 per cent annually. An investor may also need to have some margin of safety against factors that may drive inflation up by one or two percentage points in a particular year.

Rejig your investments: In high inflation scenario, a reasonable and real rate of return can be expected from investments in assets such as equity, commodities and real estate. Equity investments, which registered negative real returns the last year following the global meltdown, have recorded stellar returns during the bull market (2004-08), even adjusting for inflation.

The Sensex return during 2004-08 grew by 30 per cent, compounded annually, while CPI inflation grew at 6 per cent. This implies equity investments can conserve capital and may offer real returns.

Investors also have a hedging option against inflation in the form of commodity-oriented mutual funds, which take exposures to stocks of commodity producers or miners.

These are bound to be directly linked to the commodity basket tracking inflation. However, unlike equity, the options among commodity linked funds are few.

Some of the commodity funds offered in India are Magnum Comma Fund, DSP BlackRock Natural Resources and New Energy Funds and Mirae Asset Global Commodity Stocks Fund.

Purchasing property also acts as a good hedge against inflation, especially for people renting it out. Data suggest that rents grew at a decent pace in the last few years, apart from providing capital appreciation on the property. NHB housing index indicates that property prices went up 17.8 per cent CAGR in 2001-07 in five major cities.

Data suggest significant capital appreciation for property investments historically, notwithstanding the recent correction. Not only is the choice of investments important but also the marco-economic outlook, especially keeping tabs on the monetary response to inflation by the central bank.

Interest rate moves: One facet of your investments directly linked to inflation is interest rates. The Reserve Bank of India has traditionally used its policy rates to quell inflation.

As WPI inflation shot up from 7.8 per cent to 12.8 per cent between September 2004 and August 2008, the RBI increased repo and reverse repo rates by 300 and 150 basis points respectively and the cash reserve ratio (CRR) for banks was raised by 450 basis points to normalise inflation.

However, current divergence in the indices may put the central bank in a Catch-22 situation as CPI growth continues to stay high, even as WPI remains low. The benign interest rate regime may not be reversed until there are signs of revival, notwithstanding the spike in food prices and fiscal expansion.

With inflation expected to go back to high single digits by this financial year-end, the market expects moderate and gradual hikes in policy rates from January next year. Lending rates are sure to trend up if that happens. And bank deposit rates may catch up only later.