Fixed returns options better in volatile market conditions

The glimmer of hope that the European debt crisis is nearing some resolution sent the stock markets rallying last week. From the deep lows of 4,700 levels on the Nifty, the markets did rally smartly enough to give a feeling that a temporary bottom must be in place. Whether the market bottom is in place or not will be revealed in due course, but one thing that is certain is that heightened volatility is the order of the day. Over the last several months, unfortunately, politics rather than macroeconomics or fundamentals have dictated stock price movements. As a result, there is no clarity on the direction of the markets, leading to further volatility.

Reason for volatility

Usually, the traditional business cycles are driven by economic growth and corporate earnings. Unlike earlier ones, the last two business cycles were driven more by liquidity in the form of stimulus rather than economic performance.

As interest rates in developed markets are kept low money is inexpensive to borrow and hence the use of leverage is unintentionally encouraged. This leveraged funds moving around the global asset markets have created a high degree of volatility.

More volatility on cards

A political resolution to the European crisis seems to indicate that the European Central Bank will go for a quantitative easing (QE). In the US too even though not explicitly indicated that there will be quantitative easing, implicitly there has been an increase in liquidity. M2, an indicator of money circulation in the economy, has steadily risen since August 2011.

Higher liquidity and low interest rates in developed markets means more leveraged funds chasing assets classes. As leverage in the system is already significant , any change in investor sentiment for the negative can create a deep fall in the markets as de-leveraging sets in.

Low liquidity, high rates here

In contrast with the global environment, the domestic markets are experiencing a decline in liquidity after the government increased its borrowing target to Rs 2.2 trillion from the budgeted Rs 1.67 trillion in the financial year 2012.

This will push up the cost of capital for private companies.

Private companies are already struggling with high interest costs and the new squeeze on liquidity will put further pressure on borrowing costs and profitability. High interest costs are advantageous for one set of people only - investors.

Stick to fixed income

For individual investors, a high interest environment is a boon. With very low capital risk, investors are in a position to earn 9-10 percent returns on their investments . In 2011, asset classes excluding fixed income have fluctuated wildly. Some commodities, mid and small-cap equity have gone through sharp capital erosion.

In this environment, fixed income is, along with assured returns, an attractive investment option. Fixed income options such as bonds, debentures, and fixed deposits should be favoured by investors till volatility dissipates. Hence, many analysts are overweight on fixed income asset class.

Investment strategy

Investors should remain invested in fixed income securities till volatility declines. As the stock markets are currently driven by political decisions rather than economic ones, any sudden change in policy could cause an extended risk rally in the stock markets. A policy move required to change the direction of the markets will be a significant one, such as a third quantitative easing (QE3) or a European TARP like plan.

Hence, investors should be vigilant and look out for momentum to return to equity. A quick rebalance to equity from fixed income investments will help maximise returns in the forthcoming year.

Source: EconomicTimes