The impact of movement of various asset classes in different economic scenarios is taken care of by using asset allocation to build portfolios.
In the recent past, we have seen some banks raise the interest rates on bulk deposits and other banks raise their lending rates. We also have news of interest rates rising in the US markets. There seems to be a lot happening in the financial markets. How does all this impact your personal finance and should you make any changes in your financial plan?
Interest rate rise in the US: This essentially means that the US treasury bonds will offer a higher rate of interest to the buyers of the bond. When such a situation arises, the money managers prefer shifting money out of emerging markets to the US bonds. This money can move both from the emerging markets equity and bonds (assuming the bonds in emerging markets are offering a higher rate compared to the US). This move can cause immense volatility in the equity and bond markets.
When foreign capital is moving out of the country, the domestic currency is likely to weaken. In simple terms, you will need more rupees to buy a dollar. As India is a major importer of oil, this will impact India’s oil import bills as we will need to pay more to import crude oil. This can in turn increase inflation.
Interest rate rise in India: India is not insulated from the world markets. Because of the flight of funds out of the country, a weakening rupee resulting in a possibility of higher inflation, the interest rates here will also be impacted. We are seeing a rise in both the deposit and lending rates.
The higher rates on deposits will make conservative investors happy. However increasing inflation will result in lower real rates of return, as goods and services costs will move higher as compared to increase in rate of the deposits.
The higher lending rates will mean EMI amount or tenure of home loans will go up. From April 1, 2018 base rate of banks will be linked to MCLR rates. This means people who have taken home loans before April 2016 in the base rate era will also be affected by changes in the MCLR (Marginal Cost of Lending Rate) of banks. Base rate system for lending by banks was introduced from July 2010. The banks set their lending rates based on a reference of ‘Base Rate’ which was computed on the cost of funds to the bank. However there was a wide variation in the way different banks calculated the base rate, hence the RBI introduced the MCLR system which proposed a uniform marginal cost funding methodology for all banks.
The Marginal Cost of Funds based Lending Rate (MCLR) was introduced in September 2015 and made applicable for all new loans from April 2016. So currently, many loans are running on base rate while all loans taken after April 2016 are on MCLR. Those on the base rate regime did not get the benefit when the MCLR rates reduced, as the base rates were reducing much slower. Now with the base rate linked to MCLR, in a scenario of increasing rates, there is a possibility that the older borrowers will get impacted by increasing rates and will end up paying higher EMI too.
With weakening currency, import of gold will become expensive. Hence it is likely that the rates of gold will go up.
Generally debt and equity as asset classes have a negative correlation, that is, they tend to move in the opposite direction. But in the current global economic scenario with increasing bond yields, the correlation between debt and equity is looking positive, that means they will either both rise or fall simultaneously.
Impact on financial plans:
When financial plans are created, there is an inbuilt buffer for all the scenarios mentioned above. The impact of movement of various asset classes in different economic scenarios is taken care of by using asset allocation to build portfolios. The impact of rising interest rates on loan EMIs is taken care of by keeping the total EMI outflows below 35-40% of the net income. Changing external scenarios are taken care of through the regular plan reviews. A good plan will thus not need a major change in case of changing external environment unless the change is very drastic, or there are changes in the personal goals or family situations simultaneously. However it is wise to request a review of you financial plan in case you feel any anxiety due to external environment changes.
a). If you have significant amount going out in EMI’s take a stock of what is the likely impact in case of increasing rates. An evaluation of pre-paying the loans can also be undertaken.
b). In view of possibility of increasing inflation the surplus in your cashflow would reduce and can impact your level of savings / investment, which in turn might impact your goals.
a). Possible volatility in both equity and debt portfolios can cause anxiety. A review of the portfolio to reiterate its validity with respect to your goals can ease out the anxiety to a certain extent.
b). The return expectations from both debt and equity should be lowered for the near term. Higher expectation and lower actual returns can cause anguish and might lead conversion of notional losses into real losses by withdrawing investments. Acting out of panic must be avoided.
a). Funds for near term goal should be placed in liquid or ultra-short mutual funds or bank fixed deposits
b). Long-term goals funds should have higher exposure to equity, this in spite of 10% long term capital gains tax that has been introduced. Opportunity of creating wealth through equity investments is higher in a volatile market than in a continuously rising market.
a). Follow your asset allocation. Take up rebalancing in case there is a major change in the actual portfolio as compared to the recommended asset allocation.
b). Continue you investments for long term goals.
We are living in a dynamic world where business cycles are getting shorter and where certain past correlations between asset classes are changing. In such a fast changing world, there is always a case for allocating a slightly higher amount towards contingencies and letting your long term money locked in growth assets.(The writer is director of Dhanayush Capital Advisors)