Opting for the right asset class is often the key factor that distinguishes a successful investor from a not-so-successful one. Equity, debt, gold, real estate and more recently, cryptocurrencies are the most favoured options that investors choose from.
But how do you choose the best asset class? That differs from investor to investor. But as a thumb rule: decide on your investment corpus, estimate how much risk you are comfortable with, assess the prevailing environment, understand the outlook on the asset, and then, invest. In short, research is key to a good investment. Here, in the article that follows, we have compared two asset classes - equity and debt.
Equity or Debt?
If one analyses the long-term returns, equity is an outstanding performer. But, that doesn’t mean equity does well every year. If one looks at historical data, there have been years when equity has delivered phenomenal returns and there have been a few years where it has seen significant erosion in value.
For equity investors, the last 12 months have been a dream run with the Nifty going up 65 per cent. More importantly, the rise has not been accompanied by any significant correction. Will the next 12 months also be as great? Or does it make sense to shift to a less riskier debt segment? Let’s dig in:
Musical chairs
Since 2011, among the major asset classes, gold has delivered the best returns on three occasions, debt has emerged as winner in two calendar years and equity has topped the chart most other times.
Let’s look at the most recent data. In calendar year 2020, gold (as per MCX data) gave the best returns at 28 per cent, while the Nifty returned 15 per cent after a roller coaster ride and debt (as per the Crisil composite bond index) gave returns of 12 per cent. It was a déjà vu of sorts as earlier, in 2019, gold gave 25 per cent returns, Nifty 12 per cent and bond 11 per cent returns.
There has been a complete turnaround since January 2021. As the year comes to a close, gold has ended up as the worst asset class giving negative returns. Equity, meanwhile, has been an outperformer, with the Nifty rallying 27 per cent. Bond returns have been flattish at just 2 per cent.
While one can’t say for sure which asset class will emerge as the winner, one can always make an educated guess. Betting on the wrong horse can set your investment goals back by many years. Imagine someone, in December 2020, moving their investments from equity into debt thinking that the rebound off covid-19 lows in March 2020 has played out. That person would have missed out on the stellar rally this year. Let’s see what factors could have a bearing on the performance of equity and debt markets.
Will the equity dream run continue?
This year’s rally has propelled markets to new highs. The Sensex has crossed 60,000—a level nobody had imagined when the index plunged below 26,000 in March 2020. Like always, there are several push and pull factors. Whether –and by how much—will the market gain from here will be determined by these factors. Let’s look at the positives and negatives--
Positives/tailwinds
TINA factor—For many There Is No Alternative for stocks. With bond yields continuing to remain low, investors believe there is no option but to remain invested in equities.
Easy monetary conditions—The US Federal Reserve has signalled that it will end its bond buying programme in November, meaning it will stop pumping in liquidity. However, many believe conditions will stay conducive for the equity markets as long as interest rates remain low. The projections are that the Fed will increase interest rates only in 2023. If that happens, next year is also expected to be favourable for the markets—notwithstanding a few bouts of correction.
India’s macro supercycle—The optimistic believe that the Indian economy is on path of a structural revival. After many years of sluggish growth, the economy is finally expected to take off in a big way thanks to supportive government policies taken over the last many years. The digital revolution, rural growth, favourable monsoon are some of the factors seen as driving economic growth.
China factor—We all know about the trouble brewing in China. The regulatory crackdown against technology companies, the debt crisis at property developer Evergrande and Beijing’s high handedness has spooked investors who are thinking twice about investing in China. Many believe India is a strong alternative for investors looking to pull out money from China and invest elsewhere in the emerging markets. As China is considered to be a global growth engine, any economic shock in China is expected to have a spillover impact on the world. However, economists say India is one of the least exposed markets to China and hence, is relatively insulated.
Headwinds/risks
Despite the positive, some believe the risk-reward currently is unfavourable to commit a large sum in the equity market. Let’s look at the concerns:
Valuation concerns: Stocks across-the-board are trading at their lifetime highs. Also, valuations are expensive as compared to historical levels. In other words, expectations are running high. Markets at current prices are pricing in a sharp uptick in the economy and stellar growth in earnings. Any disappointment on earnings or growth could lead to a pullback in the markets.
Limited further upside: The one-year forward price targets set by several brokerages have already been hit. This would leave little room for upside. Many market pundits believe the returns over the next one-year period could be negative or in single digits. Many say the markets could undergo a time correction—which implies stock may not fall but will also not rise much from current levels.
Unwinding of stimulus: The post pandemic stimulus programme unleashed by global central banks is by far seen as the biggest factor driving the market higher. Now with the economy coming back on track and concerns around inflation surfacing, these extraordinary stimulus measures will be unwound. This will entail the end of the bond buying programme by the US Federal Reserve (called tapering). Any eventual hike in interest rates to ensure inflation stays in control could cause a drawdown in equity markets worldwide.
Pandemic risk: Another worry for the market is what if COVID-19 continues to linger. Several countries are reporting a rise in infections due to the spread of the delta variant. If the virus mutates further, spreads and current vaccines prove ineffective, we could be back to square one.
Let’s now look at the Debt market.
Debt markets outlook
The yields on offer currently on most debt instruments continue to be low. The post-tax yield on 10-year government security or bank deposit, remains below inflation. This is because like the US Fed, the Reserve Bank of India (RBI) too is maintaining an easy monetary stance to support the economy. This has suppressed returns for debt investors. So while equity markets are pricey, the yields on offer in the debt markets also aren’t attractive. The entire money market has been operating below 4 percent yield. This presents a big conundrum for investors. Many, however, believe things could change over the next 3-6 months. Market watchers expect a normalisation in economic activity and growth would prompt the RBI to unwind its extraordinary stimulus policies. This would mean withdrawing the extra liquidity support and series of interest rate increases in 2022. As one moves closer to policy normalisation, the yields could turn attractive vis-à-vis the equity markets.
Within debt one can look for slightly lower rate (non-AAA) corporate paper (credit risk) to boost their returns. Experts say this is one area that could do well as the economy revives.
Bond yield versus earnings yield
Many investors compare the 10-year bond yield with earnings yield (can be arrived at by dividing 1 by price-to-earnings ratio). Let’s look at how this works, the Nifty 50 index’s P/E based on FY2022 earnings estimate works out to 25 times. As a result, the Nifty earnings yield works out to 4 per cent (1/25). Meanwhile, the yield on the 10-year g-sec currently is 6.2 percent. So the difference between the earnings yield and bond yield is 220 basis points. Analysts say a yield gap of more than 200 basis points is bad for equity market returns over the next 12 months.
What should investors do
Given the prevailing situation, experts say while one should continue to remain invested in equities, one should keenly eye what Fed and the RBI are doing. Whenever the RBI moves towards policy normalisation, the returns in the debt markets could turn attractive. Probably that is the time when one can look to shift to the debt market as yields on offer would turn better.
Bottom up approach, stock/sector selection
At the benchmark index level, the market returns could be flat or negative next year. However, experts say there are always opportunities from a bottom-up perspective or at a sector or theme level. Even during a bad year for the markets, there is always some pocket or a theme that could do well.
Meaning it all boils down again to Research. Keep track of the latest developments, do your research and then invest!