Risk-off Mode Triggers Investment Outflow

Short-term debt funds with flexibility and low volatility will take center stage

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In the scenario when there are supply chain bottlenecks, inflation widening the cost of funds, commodity and raw material prices breaking all the records; the CRR and Repo Rate hike followed by US Fed interest hike by 50bps, was rather expected. Inflation usually shows signs to cool down in summer, but US announcements regarding the deal with European leaders to increase shipments of natural gas have sent out a signal to investors that there will be no softening of energy prices over the summer and inflation in the US is there to stay for longer than anticipated.

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The inflationary pressure which might propel the Fed to increase rates to the extent of 300bps has triggered the risk-off mode situation. Investors are seen pulling out investments despite reasonable valuations in place. Interest rate increased by US Fed makes US dollar appreciate against every global currency including the Indian rupee. The rising rates are making US treasuries more attractive and hence investors flee emerging markets to the perceived safety and attractiveness of US fixed income. FIIs withdrawal of INR 6,400 crore from Indian markets in May 2022 alone is a case in point.

In the risk-off mode, investments are primarily in debt, and most of it looking towards the west, the debt component in the domestic market should have features like flexibility and low volatility attached to it. This is where the shorter duration funds, in an increasing rates environment, become extremely attractive as they are least impacted and have the ability to then take refuge with commercial papers at higher rates.

Target maturity funds work well, especially when they have a short duration. It is always better to avoid long lock-in at this rate, but if one can sustain the volatility, Gilt funds with four years of maturity giving 6 per cent-plus returns, can be considered. The idea is that even when the volatility is bound to change the NAV over the holding period, the funds will deliver the net yield-to-maturity (YTM). It should be noted that while opting for these long-term Gilt funds beyond three years the taxation is 20 per cent with indexation. Hence YTM net of expenses is what investors should focus on.

As far as the equity component is concerned, investors should ensure that the businesses they own should have positive cash flows, high pricing power and zero debt on the balance sheet. The tech companies on NASDAQ bring to the table these monopolistic features. The corrections in these consumer discretionary businesses have made their valuations even more attractive.

Considering the US dollar is the most sort after and appreciating currency globally, investors need to create a USD asset for current and future USD liabilities like international vacations, and Ivy League education for their children. This translates into continuous dollar expenses.

Also, on average, the the Indian rupee has depreciated by approximately 3.5 per cent compounded over the long term. The depreciation is not always linear, but in bouts and the trend is likely to continue. In fact, the rupee has even breached the 77 mark, much before the time it was anticipated. So having a meaningful diversification to USD investments gives insurance against INR depreciation to some extent.

USD is the reserve currency and having USD assets can be of great help in times of crisis. to manage geopolitical risks, investors must have access to offshore USD assets.

The geopolitical situation has led to a significant jump in inflation and appreciation of the US Dollar against all currencies. This is seen to be attracting investment in US markets, but in the case of India Liberalized Remittances Scheme (LRS) appears to be the only option available for some time to come.

Many Indian mutual fund schemes invest in internationally listed companies. Some of them are Feeder funds, they collect funds from Indian investors and simply buy units of an actively managed fund domiciled outside India. Currently, this option isn't available as the Indian mutual fund industry has reached the SEBI prescribed limit of USD 7Bn. Another category of Indian Mutual Funds, which invests in ETFs listed internationally has a SEBI capped limit of USD 1Bn which is also likely to be reached in due course, and hence it may also not turn out to be a viable option. Also, as this investment mode is still an INR denominated one, it does serve the diversification benefit and does not offer access to USD currency.

The RBI allows to remit up to $250,000 per person in a financial year, this is called the LRS (Liberalised Remittance Scheme). This remittance is towards all your foreign currency expenses, including investments outside India. These investments can be made in ETFs, stocks, and actively managed funds. Money can also be deployed through some boutique investment managers who run niche concentrated strategies focusing on growth companies with high ROEs and free cash flows. The advantage of the LRS route is that the accumulated investments can be sold/redeemed at any point in time to generate a large USD balance which can be used for any expenses/investments. We have seen that HNIs are increasingly utilizing these limits to remit monies outside India and gradually building a corpus of offshore assets.

With SEBI limits on Indian funds investing internationally, investors are resorting to increased LRS where the limit is not on the fund but rather individually, which in turn resets every financial year.