Gold prices are ruling at 25-year-highs. Indian stock indices are trading at their highest ever values. Usually, bullion rears its head when equity markets do not do well, as savings seek safe haven. So why do we have this unusual combination of high bullion and stock markets?
Stock markets have risen steadily over the past 15 months on the back of sustained growth in the profitability of corporate India and an increasing influx of foreign portfolio investments. Initially, the markets took some time to come off its lows in recognising the structurally superior corporate performance that's being currently witnessed. Therefore, there was a big surge in the index values, which induced scepticism about the sustainability at those higher levels (up from the 5,000 levels of the Sensex to 7,000).
In the meanwhile, India took centre stage in the world reckoning and became a favourite market for global investors. They started allocating more to Indian equities, which resulted in a steady inflow of foreign institutional money. This surge continues and has taken the indices to new heights.
Even though in a recent article I had argued that the equity markets are reflecting fundamentals, the subsequent rise now appears more reflective of the buoyant inflow of foreign portfolio funds than the strong fundamentals of corporate performance alone. Given this rich valuation, I think it is prudent that fund managers hedge some portion of the funds under management against the possibility of a downside in equity prices.
This downside could be possibly caused by a reversal of this flow or even a perceptible slowdown in the rate of inflow.
There are only a few instruments of hedges available, because of the peculiar position in which the debt markets are poised. Both due to the cautionary messages issued by the RBI and the continuing tightening of interest rates by the US Fed, and the lack of clarity that such tightening is over, the interest rate outlook continues to be bearish or uncertain at the least. Therefore, fixed- income securities do not offer any succour for the moment. Indeed, there is a flight of investment from bond funds into the equity portfolio.
Commodity prices are also ruling high on the back of lack of investment in both mining and processing in core materials like oil, metals, and minerals. Real estate prices have also hardened, despite an increase in supply in recent times, in response to the steady pick-up of investments in this asset class. While inflation still can be considered moderate, given the relatively low interest rates right now, the real income from investing in fixed-income securities is unlikely to yield satisfactory returns on cash.
And there is always the fear of inflation rearing its head again, with all commodity prices remaining firm and the converters running out of the productivity improvements.
Globally too the picture is pretty constraining. Frontline stocks around the world are trading near highs and do not offer great upside. Global interest rates are also rising. Increase in US interest rates is also strengthening the dollar against most currencies and therefore triggering a massive portfolio rebalancing. While this is good for the dollar, continued scepticism about the US economy in the medium term is not making funds revert to the US equity wholesale.
Like India, other emerging markets have also done well, both reflecting rising fundamentals and a greater influx of foreign funds. At this stage, emerging market equities as an asset class also look well-priced.
On the supply side of investible surplus, the sustained high oil price has led to new investment pockets re-emerging. This has added to the pool of funds seeking better returns, safer havens and a liquid parking place. While there is a build-up in fresh capacity for manufacturing and infrastructure, it is still largely self-financed or equity-funded, without the impinging on the financial systems.
Therefore, the liquidity continues to be good, in fact getting better, thanks to the higher oil prices creating fresh new investible pockets.
Given the abundant uninvested surplus, and limited upside that various financial asset classes might return and the uncertainty surrounding the dollar, gold appears to be the right parking place for at least part of this liquidity pool. Gold is liquid and free of credit risk. The only downside is price risk.
Given the lack of alternatives to park the burgeoning liquidity surplus, the expectations appear to support continued inflow in gold at least till one of the following events happens:
On the other hand, surge in oil prices, continuing US interest rate hikes, turbulent currency markets, collapsing equity markets or conflict escalations are likely to fuel gold prices even higher, as it becomes the most absorptive asset of the increasing global liquidity in search of a safe haven.
Given this situation, what is the best an investor can do in India? It does not look like global liquidity will disappear in a hurry. In fact, it looks well poised to continue to grow rather than dwindle at least for the next few years, till a massive capacity building binge overtakes the world markets.
So the trick is to identify the extent of overvaluation and also the proximity to price reversals of various asset classes. Then allocate savings in the reverse order so that the least amount of the assets is exposed to most risky assets.
I characterise the markets as tricky only because of the historical highs they are currently trading at. I have no concern on the fundamentals supporting the various markets. However, given that external liquidity is also resulting in part of the current prices, it is important that investors be alert to the position of the foreign inflows into the country.
Any reversals or slowdowns there will cause the market to adversely react. Regulators and governments have by and large have really been very proactive in guiding investors from time to time. Therefore, it is going to be very difficult to knock up their doors to blame them, as is usually the case whenever the markets go down.
This time clearly it is the market peculiarity that has caused the current situation and nothing but a vigilant oversight of the markets by the investors will help them manage their assets most prudently and safely.