Rising REAL Interest Rates

“We have one of the highest interest rates in the world. All we need is nail hole in the bottom of the boat and we’re sunk” – Pauline Hanson (Australian Politician)

Most of us understand nominal rate of interest which is why 10% FD rates and 9% tax free bond rates seemed like a no brainer and attracted us to invest heavily in them during 2010 to 2014. The fact that most people missed was that these rates were still lower than inflation and we were losing value of money by investing at these attractive nominal rates. REAL interest rate (RIR) is the difference between nominal rates and inflation. (REAL interest rate = Nominal interest rate – Inflation). Contrary to nominal rate, REAL interest rate has a bigger impact on value of money and sadly most of us fail to track and understand its significance.

Negative RIR of 2010 where FD rates were lower than Inflation by almost 6% forced everyone to misallocate towards physical assets like real estate and gold to beat inflation.

The fall in commodity prices in 2015-16 by almost 40-60% changed the situation upside down. Consumer inflation started falling from a sticky range of 10% to 3% as we speak. Wholesale inflation was already weak as businesses were finding it difficult to survive during high commodity prices and could not pass on the cost to end consumers. Today we have weak consumer price inflation as well as wholesale price inflation. RIR has turned positive to almost above 3.5%. Good monsoon, strong currency and fall in commodity prices are pushing inflation further down. RBI policy of not cutting rates and focusing on inflation control is making things worse.

The general consensus is that nominal rates have bottomed out and due to fall in inflation RIR’s are rising sharply. We are at almost 15 years high in terms of RIR and this situation can best be termed as an investors delight and borrowers curse. Unfortunately all of us don’t have experience of operating in such an environment. Last time we witnessed similar high RIR was in year 2000-2002.

Effects of high RIR can be damaging for asset owners. I would like to put across my thoughts on emerging scenarios in time to come. Hope we can act in advance and prepare ourselves from damages caused by high positive RIR.

Residential Property in Dark Tunnel – High positive RIR hurts physical assets the most and hence residential property will be worst hit. Post 2000 – 2002 there was high RIR and we witnessed residential property hit multiyear low in 2003. Two BHK in premium Lower Parel area was available at 30 Lacs which is now almost 3-5 crores. Residential property prices collapsed during 2003 and majority of them sold their property at deep losses after waiting for 6-8 years. We are again entering a dark tunnel where high positive RIR will turn every property owner into seller and buyers will vanish. High RIR will make weight of housing loan heavy and borrowers will find it difficult to service loans. RIR of 3.5%+ can make house prices fall by almost 30 to 60%. Mortgage rates of 8.50% and less than 2.00% rental yield is making matter worse. Residential property owners would be well advised to sell vacant or unproductive houses immediately to deleverage as well as improve their cash flow. It will be better to take a knock by selling at small discount today than deep discount tomorrow.

Stock Market Poised for Vertical Rise – Consensus on the street is forecasting that market is in a 2003-2008 like bull market. I on the contrary can see lot more similarity to 1998-2000 bull market. In that bull market huge liquidity got into capital markets and created bubble. 15 year high positive RIR are driving everyone towards capital market. There is TINA (There Is No Alternative) effect at play here as well where investors are shunning large investment vehicles like residential property and fixed deposit. As we speak fixed deposit growth is at 12% and credit growth is at 50 years low of less than 5%. Banks are forced to discourage deposits and encourage investors to move fixed deposit into mutual fund or other capital market instruments. There is excess deposit of 8 Lac crore trying to find investment opportunity whereas mutual funds itself are mobilizing close to 15000 crores inflows per month. In the next 12-18 months we may see huge demand for stocks (3-4 Lac+ crore) from domestic investors. Any sharp revival in FII flow can just fuel the fire where supply of paper will find it difficult to match this demand. The weak business environment of the past few years has not allowed any new sector to emerge. Excess demand can create huge spike in market and stocks in the next 12-18 months. After 2 years plus consolidation at 30000 Sensex, market is poised for sharp vertical rise. Investors need to move their money into market quickly to take advantage of this sharp vertical rise.

Government Securities Offer Best Risk Reward Ratio - High RIR are best for Government Securities. With zero default risk and REAL rates more than 2.50%, it is really a no brainer. As we speak it is the most hated asset class as many believe that nominal rate of 6.50% is low. High REAL rates in 2000-2003 period generated annualized return of more than 20% in G-sec focused funds. Investors are advised to move part of their fixed deposit, short term debt fund & credit fund into high quality G-sec fund. Since MODI government came to power in past three years, G-sec fund returns has beaten all the other asset class.

Banking & Financial Services Sector Almost In Euphoria Zone – Banks represent more than 30% of Sensex. Majority of institutional investors are overweight on banks and there is strong consensus amongst investors on prospects of banking stocks. Low nominal rates and prospects of revival in credit demand is making everyone herd towards them. Majority of the same investors hated banking stocks in 2013 when dollar was 69, RIR was negative and banking stocks were underperforming. We can already see record supply from this sector. QIP, promoter selling & IPO from banking and financial services companies has been a feature in 2017. Supply of stocks have exceeded 30000 crores in current calendar year and listed market cap of banking & financial services sector is close to 20 Lac crores. It will take huge amount of buying just to move sector by even 5%. All signs of danger are around like – life time high business margin, weakening underlying asset, huge supply, large number of IPO, increasing competition, declining demand & low promoter holding. Still confidence amongst institutional investors is at life high and making them over own the sector. Investors are advised to be extremely selective with banking stocks, also they will be advised to look at other sectors like consumer, auto & auto ancillary, engineering, logistics & manufacturing sectors and diversify aggressively.

To summarize investors will have to bite the bullet and take a lot of hard decisions to safeguard themselves in the future. One needs to lighten their balance sheet by moving out of unwanted residential property - probably at a small discount, quickly move into equity and move accrual fund money into G-sec funds to lock high REAL rates.

Year 2003 was a period where cash flow was king and crorepati’s were envied. Are we getting there in the next two years?