Spiking interest rates or hurting the Rupee

The profligate ways of Sri Lanka’s budget has landed the country in balance-of-payments trouble, again. This is the major challenge in allocating a long-term portfolio

Savers were piqued by year-long positive real returns since annual average inflation dipped below five percent in June 2014. Real returns that six percent risk-free rates and two percent annual average inflation provide are unprecedented in Sri Lanka and exceptional by any standard.

However, the Central Bank’s misaligned monetary policy will force it to hike rates and devalue the Rupee. Depreciation, a rate increase or possibly both will hurt consumers and savers. For those trying to build a relatively low-risk long-term portfolio, it’s a particularly challenging time.

Analysts are divided on how well Sri Lanka will weather balance-of-payments trouble and if it can manage a soft landing. Consumers took almost two years to recover from the economic shock of the last BOP crisis in 2012.

Four capital market professionals – two portfolio managers, a stockbroker and an economic analyst – weighed in on the challenge of building a long-term investment portfolio in the current climate. Founding Director of Lynear Wealth Management Naveen Gunawardane and Guardian Fund Management’s Sumith Perera – both fund managers – were joined by Executive Chairman of stockbrokerage Asia Securities Dumith Fernando and economic research firm Frontier’s founder Amal Sanderatne in a discussion about long-term asset allocation challenges.

Here are excerpts of the discussion.

With an election around the corner, there is some uncertainty in the short term. But look at the long term. What do you think are those high level opportunities for investors?
bdfjlNaveen: Ultimately it’ll depend on who comes into power because the policies are very different. But the present regime is focused on a consumption-driven economy. So as an investment opportunity the couple of areas to focus on would be consumption-related opportunities. Also, unless we get our exports growing again it’s going to be difficult for Sri Lanka in the long run.

We need to bear in mind what’s happening globally and what’s happening in Europe – which is going through some pain with Greece. So you have to work around these, but the opportunities are consumption and export related.

Dumith: The thing to look at is the growth of the consumer and that goes beyond narrowly defined consumption. Consumers, to me, means personal income going up, disposable income rising and people being able to afford more than bare necessities. We are coming to an inflection point hitting this middle class with $4,000 GDP per cap levels. To me, what is really interesting will be what will happen in a couple of years beyond that when we reach $5,000 to $6,000 levels, which a number of regional economies like Malaysia have gone past, and that’s when excess disposable income allows you to spend more freely on consumer goods and buy products like insurance policies. Right now life insurance penetration is low, lapse rates are high. Demand for banking for mortgages, insurance and consumer products will grow. Along with that the investment into education and technology – Internet penetration, which is 25% – will grow, creating opportunities. So everything that relates to more money in your pocket, better sense of awareness, better education and moving up the aspiration value chain are opportunities.

It is inevitable that rates will have to pick up by around 100 basis points in the US over the next 9 to 12 months, and it would be foolish to try and maintain low rates here.
Dumith Fernando

Amal: I’m going to give you a contrary perspective – that’s a trap. I’m coming from my macro focus. Sri Lanka has a high probability of running into a balance of payments (BOP) crisis quite soon. We’ve had this consumption boom which isn’t sustainable; rates have been too low and you need a pretty sharp adjustment, which is being delayed and liquidity is being pumped in. So if you go by history, I think there’s a high probability of our usual four/ five year overheating.

The last one was in 2012. However, this depends on how, after the election, policy makers can change track. The Central Bank can change track and tighten (interest rates) faster. On the fiscal side a lot of things will matter, and right now we are in that cycle and it will end up with the usual dramatic rise in rates, maybe the exchange rate may depreciate. To me the opportunity is to stay in cash and not invest but wait because assets become very cheap, both fixed income and equity, and then when the dust settles you have an opportunity. It’s not too far away, it’s within the next year or so.

Sumith: We are now in a bit of a booming consumption phase. In 2012, there was a huge shock to consumption with the Rupee’s sudden depreciation. It then took consumption spending a long time to recover and we have only now reached that point. So what you don’t want to see is a sudden depreciation that would just shock the positive consumption growth. A steady more predictable depreciation can maybe moderate consumption and bring imports into balance rather than shocking it.

The way things are, staying in cash at the moment is probably an opportunity and then when rates do pick up you have the opportunity of going to longer term instruments. Because of the election and uncertainty around that you’re seeing many foreign investors selling equity and that offers opportunities. Many good stocks are available at relatively cheap prices for the long term.

We are probably in BOP trouble already although policy hasn’t reacted to it. Where do you think interest rates and exchange rates will settle towards year-end?
Dumith: This crisis was very much liquidity driven. It is inevitable that rates will have to pick up in the short term by around 100 basis points in the US over the next 9 to 12 months and it would be foolish to try and maintain low rates here. Our export competitiveness will be affected significantly if the currency doesn’t depreciate somewhat. A depreciation will probably bring back some of the equilibrium on the import side. We would probably see more constructive FDI (foreign direct investment) coming through here unlike what we have seen in the past. There will be some relief coming through and we should be in a position to manage. GSP+ (lower tariffs for Sri Lankan exports to Europe) being restored will open areas and be potentially beneficial.

Isn’t an adjustment inevitable? Dumith says FDI flows and the GSP restoration will perhaps make it unnecessary.
Dumith: It is inevitable; there has to be some depreciation.

dvsvNaveen: I think we are all in agreement that the currency has to depreciate somewhat and that rates have to rise. If it’s done properly, then there won’t be a shock.

An adjustment will be a shock, would you agree?
Sumith: You have to understand that compared to 2012 the circumstances are different. Oil prices were much higher and low rainfall had forced us to depend more on thermal power generation. Here the differing factor is probably an inevitable increase in FOMC (the monetary policy making body of the US Federal Reserve) rates. So it’s a little different here, but if you allow both indicators (interest rates and the Rupee) to gradually go, then you can probably avert a crisis. So it depends on how it’s managed.

Look beyond the next six months; let’s assume we’ve done this adjustment. Then we are at the beginning of 2016? What are those early opportunities?
Dumith: One of the questions that everyone seems to be asking in the context of the policy debate now is “what’s going to be our secret sauce for growth?” People thought it’ll be our infrastructure but that seems to have stalled, and even if pro-infrastructure politicians come back to power I don’t think this is going to be sustainable in the long term partly because in the way it’s financed and partly because of how it’s impacting national product. However we need to think about where we are going to put some bets down. We have a five-hub policy and so on and even those who have been in government for the last six months have started to push developments around logistics.

We will also realise pretty quickly that we are not going to be a low cost producer in a lot of export industries, so we have to move to knowledge. US economic growth is slowing, it will be about 2.5% next year. If you break it down, the knowledge economy in the US is growing by 6%. With the right quality education we can invest in the right areas and move forward. We are not going to be able to compete in the BPO (business process outsourcing) space with India.

Rates going up can actually support the banking sector. All this turmoil is good from an investment perspective. People also need to realise that they can’t do it all themselves. So that means the insurance sector and a few other sectors are also primed for growth.

Dumith talks abut the knowledge economy, but are we ready for that? If that opportunity exists, can we grab it?
Naveen: For 15 years many companies here have been trying to push the knowledge-based industry. One of their biggest challenges is getting enough skilled people. Opportunities exist, the people are the limitation.

Sri Lanka has a high probability of running into a balance of payments (BOP) crisis quite soon. We’ve had this consumption boom which isn’t sustainable, rates have been too low…
Amal Sanderatne

How does this relate to asset allocation?
Naveen: We’ve been discussing equity, but we also need to look at fixed income. A mistake a lot of investors make is that they don’t know on what part of the curve they should invest. It depends on your interest rate expectations. You have to make a decision if you are going to be on the short end or the long end.

Sumith: We have noticed, post-war, a lot of investors, institutional and high net worth, focusing on extending the duration of their fixed income investments. This has mostly been because of confidence that rates are going to fluctuate around a lower band compared to the past. Earlier on we used to wait for interest rates to hit 20-25% but now it’s more challenging. Fixed income returns are now fluctuating between 7% and 14%. Confidence has returned to the long end of the yield curve, and we are seeing debentures at higher rates and even longer bonds are trading. They have to now look at risky asset classes, which is why equity is something investors have to consider.

Naveen: And also different types of instruments are now available. We’ve seen zero coupon bonds which are ideal for certain types of investors, also floating rate debentures; and it looks like the securitization market after years in hibernation is active again. We’re also beginning to see a little bit more of secondary market trading on listed debentures.

So there are plenty of fixed income opportunities for investors to tap.

Dumith: I think we have a fundamental problem in terms of investable assets. When our entire market cap is in a bit of Rs3 trillion, fixed deposits are Rs2.9 trillion, savings accounts are Rs1.5 trillion, the treasury market is probably Rs3.6 trillion and then corporate debentures are Rs130 billion. All of these have been by and large buy and hold markets –it’s the same with real-estate. This tells you that there aren’t investable opportunities and the one thing we need to do is think about liquidity in our market. Our equity market cap is 30% of GDP. If you look at Malaysia it’s 150%. In Thailand and such countries that number is 100% and others are well above 50%. The fundamental reason is the state sector, which dominates a big part of the economy. And I cannot think of any other country in a similar stage of development where the banking sector has not been listed. Communist China has listed its banking sector. They are not privatized but they are listed. Bank of Ceylon will become the largest market cap by far if it is listed. So we need to think about policy. Our conversation keeps coming back to policy and politics.

In an asset allocation point of view it’s hard to make data-driven decisions because the data sets for back testing just don’t exist and there is no transparency. So the first step is to think how we can grow each of these, and how we can make them more investable to other than the richest.

Naveen: Liquidity is a huge issue in our market and everyone has been talking about how it needs to improve. Also keep in mind that liquid markets give you opportunities in terms of mispriced assets; so as an asset manager one of the things we continuously look out for are these mispricing to see if we can capitalize on them. When an illiquid market goes into panic that’s also a fantastic time for a long-term fund manager to start jumping into the market.

We have to increase the liquidity in our existing securities because as people’s spending power increases and more people start investing in the market we are going to have a large amount of money chasing a small amount of opportunities, which is not great.

Sumith: There are opportunities in illiquid markets but the opportunities are far greater in a liquid market.

Let’s look beyond the short-term uncertainty over the rest of the year or up to early next year. Where will you then invest?
fdsNaveen:That all depends on the individual – your business profile and your liquidity requirements. If you’re on the fixed income side you probably are right now on the short end of the curve. There is opportunity. Given the liquidity situation in our market if you’re a long-term investor probably now is the time to start picking up new stocks. Given the liquidity situation in our market, if you are a long-term investor, probably now is the time to start picking up good stocks. In the short term you will have to ride it out and if you are a long-term investor who does not have to mark to market on a monthly basis this is the time to start picking those stocks you are interested in.

Amal: One of the mistakes a lot of people make is either they don’t know what’s going to happen, they don’t take a view on things or they take a 100% view and say that equity markets are going to just go up, so they put everything in or they read what we say and say “oh there is a BOP crisis”. Right now we are at 70% probability that a BOP crisis will happen and maybe that will go to 80%. An alternative positive scenario is that immediately after the election a flow of foreign money starts coming in; this is an outlier positive scenario. But when I have a 70-80% view that we are likely to go into BOP trouble I would rather wait.

Dumith: It’s worse than most markets because it’s illiquid, you have an intermediary community that is not entirely ethical, and research that is shallow for the most part. We can sit here and say we think it’s a great industry, we are the best in South Asia. As an industry we should be benchmarking ourselves with more developed markets. These conditions make it dangerous for retail investors. Institutional investors partly because of their buying power are somewhat immune to these, and they get access to the best research probably ahead of time. They do it in sites where they can be the price makers and not the price takers. Intermediaries will think twice before they pull a fast one on a large investor. So there are a number of reasons why if you are small you should try to invest through both professionals and through scale.

What are returns in equity we can expect in the three years from 2016?
Sumith: We did a calculation going back about 15 years and found that the equity market (the all share price index) gave an 18% return.

One-year T-bill returned about 12%, which is quite high in the current context. So there’s a premium on equity. So the question is not how much of a return you can expect over the next three years, it’s more a question of whether you’re allocating into the right asset class to get a premium you expect or basically getting a higher return than what you could’ve got. So you find a lot of investors go 100% in and that is not asset allocating. A lot of investors lack discipline. If you’re a long-term investor you have to have an allocation to equity, otherwise you won’t enjoy those 18% returns for 15 years, if you try to come in and go out of the market all the time. Short term stock investing is unpredictable. If you stay for a long term there’s a very good chance that you’ll get a positive return that beats all the other asset classes. So it all depends on the individual’s allocation needs in terms of the risk requirements, liquidity and so on.

There’ll be an impact from a rate hike but I’m not convinced a 200 basis point rate hike would result in a massive tactical asset allocation out of equities into fixed income on the institutional side.
Naveen Gunawardane

Dumith: We need to think about volatility alongside return.

I would expect returns of 15% to 20% over the next three years. There are a couple of caveats and those are that there be stability in government and that we won’t have another election for another two years. I’m also assuming that we will navigate the BOP crisis with a soft landing.

Naveen: Another question you should ask yourself is what is the expected fixed income return, and figure out whether that equity return premium makes sense.

There are people who would want to have trading portfolios and things like that, but if you’re looking at it in terms of retirement, you’re really looking at more of a longer term view and this question about how much you should have in equity versus how much you should have in fixed income is part of the asset allocation decision. I think the equity return is going to be around 15%.

Amal, are you that optimistic? I’m assuming we are looking at T-bill rates of 6% -7% over the next three years?
Amal: I’m working with the assumption that there is a 70% chance that there is going to be a BOP problem, which takes equities down by 10% because of the crisis.

Sounds like a steep decline?
Amal: Indulge me; 10% because of the BOP crisis and from that point we see a 15% annual recovery. You make 55% over three years but you lose 10%, so it’s a net 45% over the entire three-year period.

If you get in right now you are looking at 45% over three years because you are taking the downward trend. Not too bad because you make 15% every year, but I’m not sure that’s good enough with the volatility when you can get an eight year T-bill at 9.6% or my favourite 30 year bond at 11% plus.

I agree about momentum investing, but my view on our market is that if you are getting into equity and allocating to equity, the way to make returns is to make that risk worthwhile. It is, in fact, anti-momentum but that’s what no one really does but you can then start looking at a 20% return when you’re timing it and you do that over the three-year horizon.

Does anybody anticipate as big a hit as Amal expects to equity?
Amal: 70% probability we get a hit.

What’s it going to take to get away from the BOP issue – a 2% interest rate rise and 5% depreciation? What do you think?
Amal: Five percent depreciation is nothing, that’s just a few bucks. I’m working with bigger numbers. We are used to a Rupee that stays solid and then we have to accept the fact that if it stays solid that it will then fall.

It depends on policy makers’ actions but I would work with a higher depreciation number than that, I’m looking at like Rs145 to the dollar level.

That’s a little over 7%. Does anybody have a view on this?
Dumith: We are not in the currency market but you’ve seen the black market rate close to Rs140 per dollar. I’d say Rs140 levels.

Amal: The thing that matters more than the depreciation are interest rates for equities. I think our equities are sensitive to even a 2% rise in interest rates.

Dumith: It’s also a matter of confidence. We’ve done enough to ourselves to break that confidence with the BOP crisis over the last six months. If the market moves down a little more you will see some foreign asset allocation to this market. It will fall less than 10% I think.

Naveen: There’ll be an impact from a rate hike, but I’m not convinced a 200 basis point rate hike would result in a massive tactical asset allocation out of equities into fixed income on the institutional side.

Sumith: I think we are all well aware of the inverse relationship between equity and interest rates, but the question is how our policymakers are able to steer through this. We would be getting off light with a 4-5% depreciation and maybe a 150 basis point interest rates rise. You could have a bunch of scenarios, but it all depends on how the key macros map out, and that’s really what’s going to drive the equity return. We (Guardian Fund Management) are a bottom-up investor. We don’t look at how we feel the equity market is going to do, and if we feel it’s going to give 20%, over the next two years; that’s not why we invest. What we do is, try to then pick the stocks that will go up by 40%. So, based on our models, we find a price where we get the return that we desire.

Investors planning for the long term seem to think it’s good to pick some real estate too. This seems to have worked so far but will it continue to work?
giNaveen: You need to remember that real estate is also a cycle, that’s something a lot of investors don’t pick up. Second you need to pick the right real estate asset. Those are decisions I’m not sure your average investor thinks about when looking at real estate. It’s almost like any other asset class, you need to think where the growth is going to come from.

Ultimately we don’t worry too much about where interest rates are going because we are ultimately stock pickers, so what we care about is the companies that we are picking and their performance. Same thing applies to real estate – are we buying an asset that we feel, irrespective of what is happening in the rest of the market, has the potential to appreciate, and are we getting it at the right price.

Dumith: There is good real estate and bad real estate. Bad real estate sometimes looks like it’s good for a brief period of time. A lot Colombo investors have been used to owning a piece of what I would call ‘scarce real estate’. I think there are the scarce real estate assets here, whether it’s Colombo prime or limited supply of Galle Fort which you cannot recreate. The success of those types of properties gives people the sense that you can never go wrong in real estate.

Despite our headline growth levels, we probably have the lowest rates of urbanization. That urbanization trend can have a massive real estate impact. We need to see some of those trends, urbanization and heavy investments in large-scale agriculture etc. You also have to think about if we going to have 500 new acres in Colombo with the proposed Port City.

Anything to add in summing up?
Sumith: We have to understand that each asset class goes through cycles – whether it be real estate, equity or interest rates themselves. So it’s a matter of being disciplined about which asset classes you want to invest in. Naturally you have to adjust your allocation as you go through the cycles.

Dumith: One thing to remember is investing without knowing your objectives is like flying a plane without knowing your destination; you can end up in a very bad place. I feel that’s what happens today with many people who are chasing yesterday’s high-return story. I’m not necessarily saying they need to outsource that to asset managers. Some will, some should, and some won’t and some shouldn’t. But I think we also need to upgrade the investment advice we give in this country. That’s something for the regulators and the industry to work together on.

Naveen: I think we talked a lot about wealth creation, but we didn’t touch too much on wealth preservation. At a certain level of wealth, that preservation angle becomes more important than creation. So that also has an impact on asset allocation. The key thing to remember is that asset allocation is not fixed, because the requirement changes and you need to make tactical changes in asset allocation. I think it is also important to look beyond the traditional asset classes of equity and fixed income. We talked about real estate, then there is art, there are also other non-traditional asset classes. One thing we haven’t touched on at all is commodities and at some point, it’s all about preservation, not creation.

Amal: I have a slightly different framework. I’ll start with the macro framework, the high probability of this BOP issue. The most important policy variable has been central bank action, and if this is not dealt with in time, we’ll be doing the wrong thing. If history repeats itself, there is a high probability of this ending up a similar thing to the past. With that kind of risk framework in mind, I’ve taken the view that you can wait. For me, I look at things very much from this asset allocation framework, top-down. I look at aggressive, three year kind of frameworks; not chasing the last one month of returns. When things are down we asset allocate on a three year view at those points when that happens.

One thing we didn’t discuss is the inflation outlook. We’ve all got used to working with 10% inflation in Sri Lanka. I think with all this, inflation may also go up from where it is now. But I think we may all need to adjust in the longer term to 7% or so inflation expectations. Then if you can look at getting 12-14%, your returns are looking pretty solid. Because of the volatility created by the Central Bank for those people who play the volatility, just buy some safe fixed income and you’re getting 5-6% real returns. So why complicate things very much beyond fixed income.

We are in fairly unusual time with inflation. It’s mostly supply side influences on inflation. Commodity prices are low, you can’t expect that they will continue here. There has to be an adjustment upwards.
Sumith Perera

To touch on inflation, what’s the expectation for the next three years?
Amal: The 30-year bond was one of these shocks. It was trading in the secondary market at about 11.75. For a 30 year old looking to retire I don’t think you have to worry about any other asset class.

Dumith: Looking at 3% to 4% inflation.

Sumith: Our outlook is also mid single digits. We are in a fairly unusual time with inflation. It’s mostly supply side influences on inflation. Commodity prices are low, you can’t expect they will continue here. There has to be an adjustment upwards.

Amal: So then what’s the point in looking at equity? Real returns determine longer-term equity returns.

Sumith: It’s a question about what your objectives are, whether they are preservation or is growth expected as well.

Dumith: Professional advisers would tailor their portfolio to people considering their age, how far they’re from retirement, their liquidity requirements, risk appetites, tax implications and what not. Each of these can create really interesting opportunities for different people.

The bigger question is, notwithstanding BOP crisis, do we see anything fundamentally different in the long-term investment horizon in this country? I’d be hard-pressed to say anything other than that it is positive in the double-digit growth on a balanced portfolio. Within that at the moment if you looked at the data you’d probably have long tails. With well-informed investment those tails will start to cave in a little.