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Flight to Quality Syndrome ✈️

Updated: Dec 17, 2022

💡 Flight to quality - When investors shift out of risky assets during financial downturn.

If you’re swimming against the tide, no matter how hard you try, you won’t be able to make it through. During financial downturns, like the one we’ve been witnessing over the last few months, there are some patterns which can help you be on the right side of the tide.

These patterns all link up to the same underlying theme - flight to quality!

The larger picture

The most talked-about shift is the FII outflow from the Indian markets. At a global scale, this is a classic one - movement of money from emerging economies to developed ones. Why does this happen?

  • Investors become risk-averse, they want to safeguard their capital.

  • Developed economies are more stable, less likely to default on their debt, have more ammo for fighting downturns, can recover from crisis with lesser damage.

  • Developed economies have certain advantages like currency stability. Look at the dollar!

  • To control inflation, central banks increase rates. Investors get higher returns on less-risky economies in countries like the US.

  • Outflows from emerging economies puts their currencies under pressure, and for global investors the currency depreciation increases the required rate of return

Result - money flow out of countries like India, and into countries like the US.

Other prominent trends

  1. Lower valuation - As earnings drop, future earnings growth becomes lower, money flows out, and risk aversion increases; investors are willing to pay lesser a price for earnings - which essentially is a lower valuation for stocks. The PE for Nifty 50 has reduced from 30x a couple of years ago to below 20x.

  2. Higher bond yields - Investors move from risky assets to less risky ones. They prefer getting interest + potential price appreciation (or lower depreciation) on bonds rather than earnings downgrades + valuation de-rating on stocks.

  3. Yield inversion - Investors move towards long term investing. Shorter term bonds start offering higher yields compared to longer term bonds. In short, there is a surge of demand for long term bonds compared to short term bonds, which makes long term bond prices to shoot up, and yields to fall more than short term bonds.

  4. Lesser investments into equity - India saw a record number of demat accounts being added in the pandemic-rally, from 2020 to 2022. However, the pace of new addition of demat accounts has dropped dramatically as the markets look tough. In June 2022, India added 1.79 million demat accounts, from the high of 3.5 million in October 2021, when the markets had touched their high. See the correlation?

In short

To summarise, money moves:

  1. From emerging economies to developed ones

  2. From equity markets to bonds

  3. From shorter duration to longer duration

  4. To safer assets like gold

  5. To liquid assets or cash

  6. Away from novel asset classes (lol @crypto)

How you can move your capital

As domestic retail investors, you have limited manoeuvrability. You can’t take money out of India, put in China, and then in the US like the FIIs do. Or move it from corporate debt mutual funds in India to municipal bonds in the US. But here are a few things you can do to be with the tide, and not against it.

  1. Diversify the portfolio across asset classes, rather than concentrating wealth in one asset class - to do this easily, invest in Rupeeting’s all-weather portfolios :)

  2. Move your equity portfolio towards large caps. Large caps tend to be more stable, have larger ability to weather the storm, and are better equipped in downturns.

  3. Move from value to growth. Growth stocks have higher earnings expectation, and trade at steep valuations. During downturns, both these factors are at risk, and can result in significant losses in growth stocks. Value tends to perform better because of limited downside on expectations and valuations.

  4. Add more defensives in your portfolio. Sectors like insurance, healthcare, alcohol and telecom tend to perform better because people don’t really stop consuming these products and services despite the downturn.

  5. Move the hell out of your fad-led or FOMO-led crypto investments!

Extra cash!

The most important during downturns is to keep spare cash. No, not the cash that you want to put aside for emergencies or to fight inflation. This is the cash you want to use opportunistically to buy when the markets fall.

To buy those stocks that become attractive, to enter those sectors that are currently bad but look promising in the long run, those pockets of the market that people are currently running out of but look decent over the long term.

As much as flight to quality makes sense, flight into what’s falling can also give you great buying prices, and make a tonne of money in the long run.

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