How much should one be exposed to equities and what proportion of ones investments be put in fixed income is a question which plagues many a mind. In technical terms what your asset allocation should beis as much a personal call as it is with regards the current economic environment. Factors like age, ones risk-taking ability, current asset base, financial goals and the market outlook are the keys to determining how much should the allocation be in each asset class. While equities have the ability to generate higher returns, the associated risk with the asset class is also higher.
A broad thumb rule for allocation to equities is (100age of individual). Thus if your age is 30, allocation to equities should be 70%. But as discussed earlier, ones risk appetite also plays a crucial role for arriving at an asset allocation decision. For this, we identify investors into three categories of conservative, moderate and aggressive. A conservative investor who wishes to minimise his risks should allocate up to 20% of his capital in equities at the most. Similarly an investor with moderate risk appetite should keep his equity allocation between 20% to 40%. The aggressive investor may allocate between 40% to 70% of his capital in stocks.
Speaking of equities, buoyed by strong policy action by the government and central bank action globally in the US and Europe, Indian equity markets have done well in the calendar year 2012, notching up gains of over 20% year-to-date. On the fixed income side, yields have softened but only mildly, with the 10-year trading at 8.15% versus that of 8.25% in the beginning of the year. Fixed income yields had declined in the latter half of 2011 from 9% levels, but post that yields have been more or less stagnant in the absence of anticipated rate-cuts by RBI.
Going forward, we are bullish on Indian equities owing to multiple catalysts. Firstly, central bank and government action at the global level has reduced tail risks to a certain extent. ECBs strong action in the form of Outright Monetary Transactions (OMTs), enabling purchase of sovereign bonds of debt-trapped Euro-zone countries, has reigned in the fear of a euro breakdown. Further, this has helped restore confidence in the euro, with sovereign yields receding materially despite a lack of improvement on the economic front. Spanish and Italian yields have cooled off by more than 150 bps since the announcement of OMTs, trading at 5.5% and 4.8% respectively.
In the US too, the Fed recently introduced QE3 in a bid to breathe more life into the worlds largest economy and boost employment. Recent data in the form of non-farm payroll additions has been quite upbeat, with the unemployment rate dipping to 7.8%. The US economy could face some risks as we head into 2013, with automatic spending cuts coming into force from January 2013. The Congressional leaders need to address the impending fiscal cliff in order to mitigate the risks to the US economy. However, we believe that the current mix of news flow from across the globe is supportive of the ongoing risk-on environment.
Secondly, on the domestic side, we believe interest rates will head south sooner rather than later. Core inflation has moderated materially to sub 5% levels as demand pressures in the economy have ebbed on the back of sharp fall in GDP growth. Further, outlook on inflation in primary articles has improved considerably in the past couple of months as the overall monsoon rainfall (though below normal) has been much better than what was feared earlier. Moreover, international agri commodity prices have cooled down considerably. The only component that is expected to push up headline inflation in the coming months is fuel. Full impact of the diesel price hike will be visible in the next months inflation numbers. Electricity price hikes by many state electricity boards will also begin to reflect in the overall inflation data. But in our view, the RBI should not be too perturbed about the imminent spike in fuel prices as these are more one-time factors. In fact, fuel price hike should be looked favourably by the RBI as it will help the government contain its widening fiscal gap (one of the long-pending demands of RBI). Further, the slowing GDP growth should get more attention, going forward, as compared to price stability. As a result, we see the RBI resuming the rate-cut cycle soon.
Thirdly, on the stock valuations front, the Indian market still trade below historic averages. India trades at a PE multiple of 14.9x FY13 estimates and 13.3x FY14 estimates, below long-term average of 15.4x one-year forward. Indian markets are quite under-owned in the sense that most investors have preferred being invested in fixed deposits and gold over the past couple of years. Having said that, investors are gradually starting to return to the stock market although a vast majority are still sitting on the sidelines. For new investors looking to get into equities, mutual fund SIPs are a recommended route, while those with prior investing experience would do well looking for stock specific opportunities in the rate-sensitive space.
On the fixed income front, we see good times ahead for investments in bonds given expected dovish monetary stance by the RBI. Investors with a 12 - 15 months view can invest in Gilt Funds with duration of sixseven years. At the same time, investors with a 12-24 months view can invest in high rated (AA/ AAA), highly liquid bonds, with maturities in 2018-2020. Long-term bonds have an attractive proposition currently, (i) High Coupon of long term bonds (ii) Yields of long term papers are trading in the top quartile compared to their historical prices (iii) Correction in yields may provide capital gains (4% to 6%) over and above the coupon rate.
Thus, attractive investment opportunities exist in both the equity and fixed income space. In our view, it makes sense to be invested in the upper end of your equity allocation range. For example, if you are a conservative investor, 15% of your assets should be in equities. Similarly for moderate and aggressive investors, allocation to equities should be 35% and 63%, respectively.
Key risks to our view include delay in rate-cut cycle, inability of the government to push through important fiscal curbs, and those emanating from the globe, such as the fiscal cliff in the US and the still unresolved European debt crisis.
The writer is headCapital Markets (Individual Clients), Edelweiss Securities Limited