The Indian economy has been performing fairly well in the past one year. The annual GDP growth rate (as per the new base year) is back to 8%. The government has shown discipline in terms of sticking to its fiscal deficit agenda and inflation rate is well within RBI's prescribed limits. Business and consumer confidence is showing relative improvement, and credit growth is also improving. However, increase in global crude prices has resulted in widening of the trade deficit. The expectation of higher inflation has resulted in the RBI raising interest rates in August to 6.5%.
The stock market has performed exceptionally well over the past couple of years, generating returns of 29% in 2017 and resulting in healthy stock valuations. At the same time, the 10Y Indian Government Bond yields have been on a roller-coaster ride moving down from 7.7% in 2016 to 6.4% in 2017 and then moving upwards to 8.0% in 2018. Against this backdrop, the question that an investor is presented with is how to distribute the weight-age between stocks and bonds in the investment portfolio.
In order to arrive at the weight-age distribution, we need to look at the present status of the stock and the bond markets.
Let us analyze the current levels of the stock market and find out whether it is cheap or expensive. If we look at the NIFTY levels versus the NIFTY's PE over the previous 10 years, we get the chart below:
If we look at the historical PE levels, the current PE levels are at par with the maximum PE levels achieved in the previous bull markets. This means that the market is paying a high premium of 28x per rupee of corporate earnings. This could mean that either the market has to correct or it expects corporate earnings growth in the upcoming quarters. Given the current strength of the economy and stability in the interest rates, we may expect the latter, although currently the market seems to be at higher valuations. Also, with the quantitative easing reversing globally, foreign investors may find the equity markets less attractive. Additionally, given the upcoming elections, I would remain cautious around the equity markets.
On the other hand, let us take a look at the 10Y Indian Government Bond yields over the previous 10 years:
If we look at the 10Y Govt. bond yields, they are nowhere at the historical highs. That is because the inflation rate is well within RBI's acceptable range of 2% to 6% (Aug. inflation rate is 3.69%, which is lower than July inflation rate of 4.17%). Also, the interest rate is at a moderate 6.5%.
Let us take a look at the yield curve:
We observe that the yield curve is rather flat, i.e. the yields are more or less the same across medium-term and long-term maturities. This is generally not a good sign and is usually indicative of uncertainty around economic growth and inflation.
In the recent past, the 10Y yields have moved up sharply suggesting inflationary pressures owing to a depreciating rupee and increasing crude prices. Also, the excess supply of G-secs has caused the yields to remain high. However, recently, the government announced easing in overseas borrowing norms for manufacturing companies, removed restrictions on FPI investment in corporate bonds, and provided tax benefits on Masala Bonds.
We may expect these favorable measures by government and lower inflation data for August to ease concerns around rising interest rates, thereby making the bond market more attractive. The higher liquidity in the bond markets in August certainly seems to lend some support. All these are signs that the bond yields may be stabilizing at the 8% levels or even turning around to lower levels.
Overall, given the present scenario of the stock and bond markets and the upcoming elections, I believe that an investor may want to accumulate more of bonds and less of stocks in the investment portfolio.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.