What is driving liquidity in the markets?

The current rally in Indian market is fuelled by strong liquidity from domestic investors. With low bank fixed deposit rates, subdued real estate market (with high transaction cost) and stagnating gold prices, equities seems to be the most viable domestic investment avenue for investors. Thus in spite of the markets reaching all-time highs & rich valuations there is very strong cash inflows into the equity markets.

One observation is that domestic institutions have been flushed with funds ever since demonetization was announced and even till date the latest rally in equity markets is purely driven by excess liquidity. It may be a mere co-incidence but it could also be possible that the notes that were previously hoarded in homes & not in circulation is flowing into the equity markets after being deposited into banks.

 Let us look at the different investment avenues in order of risk expected returns:

Liquid funds, ultra short term fundsLess than 1 year6.5-6.7%Safe. Liquidity with some extra return over normal savings a/c. Taxable returns.
Bank FD1-5 years6.7-7.2%Safe & fixed returns. Marginally extra returns with liquidity but fully taxable other than 5 year FD.
Gold3 years+6-8%Returns not guaranteed. Moves in contrary to equities & does well in times of global distress.
Debt funds1-5 years7.5-8.0%Safe but returns may fluctuate. LTCG indexation if held more than 3 years.
PPF, SCSS, EPF, PMVVY etc7.8-8.65%7.8-8.65%Safe & fixed returns. Extra returns but illiquid. Mostly long term government savings schemes.
Hybrid funds1-5 years9-11%Marginally risky. Extra returns due to mix of equity & debt in the portfolio.
Real Estates3 years+10-15%Risky, returns may fluctuate. Illiquid long term investment. Transaction cost of buying & selling is very high (12-15%) & lengthy. LTCG indexation after 3 years holding
Equities3 years+14-16%Risky, returns may fluctuate. Capital appreciation, Liquidity. To achieve high priority long term goals. Tax free after 1 year.

The objectives above are in the order of priorities as well as return which means the liquid fund should be looked for first as liquidity then return, similarly while investing into equity one should keep the capital appreciation as top priority even if it offers liquidity that automatically sets condition for long term investing.

One should look at post tax real return i.e. (Real Return= Return-tax-inflation). Thus for each of the asset classes they should atleast beat inflation post tax to be viable. With inflation currently at ~3-4 all the above assets may be generating positive returns but bank FDs would be giving you the least post tax returns amongst all. (Assuming liquid funds are invested in for 3-6 months to take care of short term liquidity & not an attractive investment avenue).

Crash course of overheated markets

Demonetization a success or failure-time will tell

Sabyasachi Paul has been associated with equity research and advisory on equity markets in India for over 9 years & currently heads the equity research desk of Eastern Financiers Ltd, Kolkata.He also manages a portfolio on the online platform Kristal. Find link to the strategy named ‘The Tortoise’ 

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