How to generate inflation-beating high returns?
During the Covid-19 pandemic, many countries resorted to monetary and fiscal stimulus to pull their economies out of the slump. It led to excess liquidity in the financial system. When a lot of money chases a few goods and services, demand is expected to go up, resulting in higher prices. In other words, it led to a rise in inflation globally. Inflation rose higher than the tolerance levels of many central banks. As a result, they started hiking interest rates since the early part of 2022 to bring inflation under control.
However, the magnitude of rate hikes and the short period in which they have been done has surprised everyone. It has led to a lot of volatility across financial markets, such as equities, fixed income, and currencies. Also, even after such high interest rate hikes, inflation has been sticky, which is why it is the talking point globally. There is much speculation about how far central banks will raise interest rates to control inflation and how high interest rates will impact consumers and credit markets. In this article, we will discuss the current inflation scenario and how you can build an investment portfolio that can generate inflation-beating high returns.
Current inflation trend
Inflation is running at a multi-decade high in the US, European Union (EU), and many other economies.
Chart: Current inflation trajectory in the US
The above chart shows the US Consumer Price Index (CPI) peaked in June 2022 at 9.1%. Since then, it has been trending lower but is still way higher than the US Fed's target range of 2%.
Like the US and many other global economies, the Reserve Bank of India (RBI) has been battling inflation in India.
Chart: Current inflation trajectory in India
The above chart shows how the India Consumer Price Index (CPI) has increased from 4.48% a year back to the current rate of 7.41% (September 2022).
In response to controlling inflation, the RBI has increased the Repo Rate from a low of 4% to 5.90% (as of October 2022). However, inflation is sticky and continues to exceed the RBI’s tolerance band of 4-6%.
How is high inflation leading to negative returns on fixed-income investments?
Let us take an example to understand how high inflation can lead to negative returns on your fixed-income investments. Rajesh has to pay his daughter’s education fees after one year. The current annual fee is Rs. 1,00,000. Rajesh invests the money in a one-year bank fixed deposit at 6.00%. After one year, he will have Rs. 1,00,6000.
However, education inflation has increased by 10%, so the school decides to hike the annual fee by 10% to Rs. 1,10,000. In this case, Rajesh will have to put the balance of Rs. 4,000 (Rs. 1,10,000 annual fee – Rs. 1,06,000 FD maturity amount) from his pocket.
In this manner, if the inflation rate is higher than the rate of return on your fixed-income investment product, it will lead to negative returns. In other words, you will have to put the balance amount from your pocket. Hence, you should always aim to earn inflation-beating high returns. In our above example, Rajesh’s aim should be to earn returns higher than 10% (inflation rate).
How to generate inflation-beating high returns?
Historically, equities have given inflation-beating high returns. Let us look at the returns given by various broad market indices.
Table: Returns given by broad market indices
|Nifty Next 50||23.55%||14.19%||7.87%|
|Nifty Midcap 150||34.01%||24.67%||12.37%|
|Nifty Smallcap 250||35.89%||25.89%||7.52%|
Note: The above data is as of 24th October 2022. The two, three, and five-year returns are CAGR.
The above table shows that the Nifty 50 Index has given returns in the range of 11% to 21% CAGR over a 2 to 5-year period. Hence, if you had invested in a Nifty 50 Index Fund, your returns would have beaten inflation.
Similarly, if you had constructed a diversified investment portfolio of four index funds (one each in Nifty 50, Nifty Next 50, Nifty Midcap 150, and Nifty Smallcap 250 category), your portfolio would have still beaten inflation.
In the above section, we saw how a Nifty 50 Index Fund or an investment portfolio with four index funds would have given you inflation-beating high returns. However, asset allocation requires you to diversify into other asset classes such as fixed income, gold, investment trusts, etc. Let us understand how you can build an investment portfolio with these asset classes.
Currently (October 2022), inflation continues to trend higher. As a result, the RBI has been hiking policy rates. Simultaneously, banks are also responding by increasing interest rates on loans and deposits. Along with banks, the Government is offering higher interest rates on small saving schemes such as PPF, NSC, SCSS, KVP, etc. Similarly, corporates are offering higher interest rates on bonds such as NCDs. Hence, this is a good time to lock in some money in fixed-income instruments at higher interest rates for the next 3-5 years
As we advance, inflation may come down, and the RBI may once again start cutting interest rates. However, for your current fixed-income investments, you will continue to earn higher rates for the remaining tenure till maturity.
Gold is considered a hedge against inflation. It is also considered a safe haven during times of uncertainty, such as the current Ukraine-Russia war. Hence, you may consider investing a certain percentage of your investment portfolio in gold. These days, some mutual fund houses have launched mutual fund schemes that offer exposure to gold and silver through a single scheme. You may consider starting a systematic investment plan (SIP) in such a scheme
Investment trusts such as real estate investment trusts (REITs) and infrastructure investment trusts (InvITs) have emerged as asset classes in the last few years. These investment trusts invest most of their money (minimum 80%) in income-generating assets such as commercial real estate or infrastructure assets (for example, power transmission lines), etc.
As per SEBI guidelines, they have to distribute at least 90% of their income (after deducting expenses) to their unitholders. The distribution yield on listed InvITs, such as Powergrid InvIT and IndiGrid InvIT, has ranged between high single digits to low double digits. The capital appreciation is additional over the distribution per unit (DPU).
Chart: Performance of InvITs
Note: The above data is for the five-year period of June 2017 to 30th June 2022.
The above table shows how the IndiGrid InvIT has given inflation-beating annualised returns of 15% CAGR during the 5-year period. Hence, you may allocate a small percentage of your investment portfolio to investment trusts (REITs and InvITs) to earn inflation-beating returns.
Asset allocation is the key to inflation-beating returns
In the above article, we have discussed how the current high inflation is leading to negative returns on fixed-income investments. However, if you follow asset allocation as per your risk profile, you can generate inflation-beating high returns. If you have an aggressive risk profile, you may allocate a higher percentage of your investment portfolio to equity index funds. You may also lock in a certain percentage of your investment portfolio in high-yielding fixed-income products. Finally, you may allocate a small portion of your investment portfolio to gold and investment trusts. A well-diversified investment portfolio can give you inflation-beating high returns in the long run.
Investing in mutual funds with the Glide Invest App
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