Inflation knocking at the door? Here is how equity, debt investments may get impacted

Historically, equities have done well when inflation is at slightly higher levels but not too high.

The fear of inflation may become more realistic in the times to come. At least, here in India, the inflationary pressure may not be as pronounced as in the developed economies, the situation may change quickly. The wholesale price-based inflation had shot up to an all-time high of 10.49 per cent in April, on rising prices of food items, crude oil and manufactured goods. Many industry experts believe that the uptrend is likely to continue. This is the fourth straight month of uptick seen in the wholesale price index (WPI)-based inflation.

RBI in its recent MPC on June 4, 2021 has projected CPI inflation at 5.1 per cent during 2021-22 – 5.2 per cent in Q1; 5.4 per cent in Q2; 4.7 per cent in Q3; and 5.3 per cent in Q4 of 2021-22, with risks broadly balanced. It remains to be seen if the inflation concerns remain transitory or become a more permanent feature in the months ahead.

When inflation rises, the purchasing power of money comes down and over time, inflation eats into the returns that any asset generates. There is a corresponding impact on the bond yields as well. In an exclusive interview with FE Online, Pankaj Pathak, Fund Manager – Fixed Income, Quantum AMC, talks about the impact of inflation on equity and debt investments, and where investors should invest now to tackle inflationary concerns.

How realistic is the expectation of inflation coming back in the Indian economy?

There are visible signs of inflationary pressures building up. Global commodity prices including agricultural commodities have moved up very sharply. Most of the companies are reporting increased input costs which may be passed on to consumers. Transportation costs have been rising for some time now. This has started feeding into the prices of other goods.

What I am more worried about is the service inflation. After the lockdown was lifted last year, we found prices of most of the services adjusting to some higher level without much demand. This is hard to control and bring down. It also creates a feedback loop and feeds into inflationary expectations which have now started to move up gradually.

One argument against the sustainability of this inflation trend is that consumer demand may not sustain given the job and income losses in the broader economy. But various studies on inflation in emerging economies suggest that in EMs inflation is more dependent on supply-side factors than on-demand. You can see it around us. Our neighborhood barber increased its prices to offset the losses incurred during the lockdown. The local snacks joint reduced the size of samosas while keeping the price the same. You can see it across all the services around you. This will at some point get reflected in the inflation numbers.

If the global economy witnesses inflation, can the Indian economy remain in a low-inflationary zone?

Global inflation usually spills over to emerging economies through the commodities channel. This is already showing up in the wholesale price inflation which captures inflation at the producers’ level.

So if inflation moves up globally, India will not be immune. Nevertheless, our inflation basket has a very high weight on food prices and most of it domestically produced and procured. That could provide some relief if domestic food prices remain soft.

Because of rising inflation, the purchasing power of the rupee gets hit. What will you suggest to equity and debt investors?

Inflation usually impacts equity and debt investments differently. Historically, equities have done well when inflation is at slightly higher levels but not too high. While debt investments face trouble in times when inflation is rising. Rising inflation pushes interest rates higher and prices of long term bonds lower. Even in fixed deposits, investors’ lose the purchasing power of their investments.

But, it doesn’t mean that investors should withdraw all their investments from debt and put that into equities. It’s always prudent to follow your long-term asset allocation. Every asset class has different characteristics and different roles to play in your portfolio.

Keeping inflation likely to go up, which type of debt mutual fund, out of 16 odd categories of debt funds, would you suggest?

With rising inflation, interest rates will go up sooner or later. Under current circumstances, investors should stick to funds that invest into short maturity bonds. These bonds and funds which invest in short maturity bonds face lower impact from the increase in market interest rate. Conservative investors should stick to liquid funds which actually tend to gain in rising interest rate scenarios by reinvesting maturing investments at a higher interest rate.