The global economy has not made a convincing recovery from the recession triggered by the subprime crisis. In Europe, larger economies like Spain and Italy are under pressure. The US has seen slow growth and high unemployment. Japan has stayed in recession. China has seen a slowdown. Unrest in West Asia and North Africa (WANA) has kept energy prices high.
India has seen its own share of suffering. Things have been made worse by the unwillingness to take policy action of any description. But a combination of slow domestic growth, high energy prices and slowing exports would have made things difficult for any government.
An investor must consider several scenarios that could occur over the next two or three years. The Indian economy will trend in the same direction as the global economy, though it may do somewhat better, or worse. India's economic prospects are tied to the global scenario because it needs investment inflows and it is dependent on energy imports. Hence, India also needs a robust export profile for a sustainable balance of payments.
There are many possible global scenarios. The worst possibilities would be price deflation, or extremely high inflation, coupled to GDP contraction. There's almost nothing the individual investor can do to mitigate such circumstances.
Ignoring those worst cases, there are some likely scenarios where the investor can respond effectively. One, the world sees low inflation coupled to low growth. In another, inflation rises somewhat and growth is slow or negative. A third sees a decent growth rebound with rising inflation. In a fourth scenario – the best - growth rebound strongly, with low inflation.
In each of these cases, different asset classes will give optimal returns. An Indian investor can build and juggle portfolios containing exposure to debt, equity and commodity baskets. They can also legally take a certain amount of forex-denominated exposure in overseas equity or other assets.
If growth is slow and inflation low, government debt (bonds and treasury bills) will do well. So an investor should look for debt funds with high exposures to these assets if he thinks this is the most likely scenario. If growth is low and inflation high, precious metals and energy commodities will do well. Gold, silver, and equity in energy sectors may offer the best returns.
The third scenario - high inflation and high growth - is best tackled by broad-based equity exposure plus some commodity plays. The fourth scenario - low inflation, high growth - is also an equity play but debt will also do well, while commodities will underperform.
If we knew which scenario would play out, we could go heavily overweight on a given asset class. The consensus seems to be low inflation and low growth is the most likely. But the global economy is going through an unprecedented situation and the consensus could be wrong. Across the world, government debt is very high and at the same time, central banks have generally been trying to ensure that there is excess liquidity. Inflation is not unlikely in those circumstances.
Making a call on the political future of nations that are the world's key sources of oil and gas is also difficult to make. Maybe the Arab nations and Iran will become stable democracies, or they will become more hardline Islamic regimes, or end up controlled by military juntas. The price and availability of oil and gas would depend on this. In India itself, there will be political uncertainty until 2014 at least, and there may not be a stable, rational government in place until 2019.
Whatever your perceptions, this situation is very fluid and uncertain. One would not bet too heavily on any given asset class. The investor has to hold a balanced mix of assets with some exposure to everything.
I do think rupee interest rates have peaked and GDP growth rates have bottomed, giving a version of the low inflation, low growth scenario. Indian inflation will still be high in absolute terms but lower than in the past two years. Growth will stay at current levels or improve, but not hugely. There is also a good chance the rupee will remain under pressure. A portfolio, which is somewhat overweight in debt funds and export-oriented businesses, will do well if these trends hold.
But it would be highly risky to ignore other scenarios. Precious metals are the obvious hedge against high inflation, or currency failure. But I'd be more inclined to look at an energy-heavy basket of commodities, or at equity holdings in energy producers. Precious metals are relatively expensive and energy will offer better yields under most circumstances.