US could be a good international hedge

It has become easier to invest in overseas equities and bonds. The tax incidence isn’t bad, now that Indian equity holdings are also subject to long-term capital gains tax. Given that the next six months look uncertain for the Indian markets, should we be looking abroad to create a hedge against Nifty volatility?

Here are some thoughts. Assume that, as a relatively uninformed investor, you would be passively tracking exchange-traded fund (ETFs) in whatever markets you follow. There isn’t much point in looking at other emerging markets (EMs) as hedges. In 2018, EMs fell in tandem and there isn’t any EM that will outperform India for sure, in 2019.

Among hard currency markets, the UK is in a more uncertain political space than India. Its economy is bound to suffer, whatever happens with Brexit. Japan, too, is dipping in and out of recession. The other major EU economies are also seeing uncertain times. In Germany, industrial activity has slumped. Recent protests in France highlighted economic problems. Euro liquidity will tighten as the European Central Bank (ECB) has curtailed its bond-buying programme. The ECB has also cut EU growth estimates. So, the EU doesn’t look attractive.

That leaves just the US as a potential “hedge” destination. The US is, of course, the largest economy, with the deepest markets, including listings of the world’s largest MNCs. It has also had a more or less uninterrupted economic expansion for the last ten years.

That expansion may finally be overheating. Unemployment is very low; there’s a massive fiscal deficit; the economy grew at a great pace in 2018. The Federal Reserve has raised interest rates nine times in the past four years. It is also cutting liquidity, as it reduces its balance sheet.

According to US economy-watchers, the bond markets and the stock markets are both indicating a slowdown. The stock market lost a lot of ground in December, and majors such as Apple and Federal Express have issued a negative guidance.

There is significant political risk, triggered by the capricious decisions of the American President, and the fact that his position is looking shaky as 17 different investigations continue to examine his finances and possible campaign violations. If that slowdown happens, the US market indices, which have already lost quite a lot of ground in the last six months, could lose even more ground.

Does all this mean that a hedge in overseas assets, even in US assets, is a bad idea? There are two reasons why it could still be a good idea, despite the negatives. One is the rupee. The rupee could weaken further, if the US dollar liquidity tightens, and foreign portfolio investors (FPIs) continue to sell Indian assets. In that case, the return on dollar assets would be boosted by the exchange trend.

The other reason is global crude prices. OPEC is rebalancing supply, by cutting crude oil production from January. This should lead to higher crude oil prices — indeed, there has been a surge in the last week. If the trade war between the US and China resolves, that will boost global demand. Since the US is now the world’s largest crude oil producer, it cannot be bad for the US economy, if crude prices stay high.

Those two variables buttress the argument for hedging into US assets. However, if you do choose to invest in the US, it makes sense to do so for the long-term, and to do it systematically. You may be buying into a bear market, where averaging down as prices fall, will be important. Both the S&P500 and the Dow offer about 5.5 per cent to 6 per cent weight to their respective energy components. As a much broader index, the S&P500 offers about 80 per cent exposure to the US market cap.

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