Bonds, equities or gold? Which is the best asset class while RBI makes up its mind on interest rates?

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But they also have good reasons to cut—steady deterioration of economic data, inverted yield curves foretelling recessions, a faltering Chinese economy and the risk of a sharp asset price corrections and debt defaults as cumulative effects of tightening show up.

The conundrum facing central banks is obvious. Tighten too little and we have an inflationary spiral. Tighten too much and the global economy falls off the cliff. Perhaps that’s why the feasible and most likely course of action at this stage appears to be a pause—a wait-and-watch approach before the next policy move till more data and, hence, more clarity emerges on the inflation and growth fronts. That’s exactly what the US Federal Reserve and Reserve Bank of India (RBI) chose to do this month. Whether this pause will be short -lived or extended will be “data dependent”.

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A year of rate hikes: portfolio implications

The tightening phase of central bank policy which started sometime in early 2022 was marked by high inflation and aggressive rate hikes. Inflation pushed up raw material prices and higher rates pushed up the cost of capital, both weighing on corporate profitability. The hit on earnings resulted in a disproportionate price correction for growth stocks with high price to earnings (P/E) multiples, compared to low P/E or value stocks.

With yields on the rise, long-term bonds, which have higher sensitivity to interest rate movements, witnessed more mark-to-market losses than their shorter-tenure counterparts. International gold prices took a hit as the dollar strengthened and higher interest rates increased the opportunity cost of holding the non-yielding precious metal. Domestic gold prices did well despite this as rupee depreciation aided returns.

A policy pause on the horizon? Lie low

A monetary policy pause would have mixed impact on markets, after an initial bout of optimism to celebrate the end of policy tightening. Some participants would be encouraged to take on more risk. Some would prefer to wait on the sidelines and delay any big moves that could risk going wrong in the face of future policy action. Thus, a range-bound movement in the various asset classes can be expected.

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Here, short-term bonds will score over long-term bonds as they continue to enjoy higher accruals with lower price volatility. As far as equity is concerned, value as a style would continue to fare better than growth as borrowing costs stay at elevated levels. Upside in gold will be limited.

Rate cuts: the bitter must come before the sweet

While one would imagine an easing of monetary policy to be entirely positive for their portfolio, one must understand that unless we see a soft landing (usually rare), any rate cuts would most likely be preceded by a growth setback or financial instability. In Part A of this scenario, preceding the rate cuts, equities and bonds could suffer amid economic vulnerabilities. Gold, which is preferred in times of risk aversion, could do well, cushioning your portfolio. In Part B of this scenario, when the rate cuts kick in, most of the asset classes are expected to do well—growth stocks could see some bounce back at the expense of value stocks, long-term bonds will see larger capital gains and gold will flourish, though rupee appreciation will soften the upside of domestic gold returns.

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If the rate cuts come despite inflation staying high, gold could do better than equities and bonds as it previously has in periods of stagflation.

Asset allocation: to optimise on the next phase of monetary policy

As evident, these are many ifs and buts facing the global economy and financial markets today. While it may seem easy to describe and navigate these in theory, the macroeconomic situation and monetary policy are dynamic and difficult to predict. An asset allocation strategy that incorporates various asset classes and investing styles that respond differently to different developments is the only reliable way to emerge from this uncertainty unscathed, and as a winner.