-->
Back to insights

Investment Insights

Suyash Choudhary

Recent Environment Developments
 
After a period of relative calm and a strong year beginning bond performance domestically, the last few days have again been eventful for markets. Towards late last year there was broad global consensus that most emerging markets (EMs) were beginning to stabilize and that incremental tapering from the Fed may be taken more in stride. However, rumblings have erupted lately in various EMs such as Turkey, Argentina, and South Africa whereas there are fresh concerns in China both with respect to slowing growth as well as the fate of some of the alternative investment products sold over the past few years. Turkey and South Africa have hiked rates as well over the past few days, the former by a significant margin while the latter quite unexpectedly. Despite this strong commitment shown there is at best a near term uneasy calm. Meanwhile the Fed continued to taper, delivering another USD 10 billion cut to its bond purchase program, showing scant regard to the EM hiccup (there was no mention at all of this in the accompanying statement) or indeed to the underwhelming employment report received in December (admittedly there may have been significant weather related distortions in that report).
 
While the above has set the global context, our own RBI has been fairly busy these last few days. The Urjit Patel committee suggested flexible inflation targeting for the RBI with the first year CPI target of 8%. Subsequently, Governor Rajan surprised most by hiking rates. Even though he has verbally sounded non-committal just yet to inflation targeting, for all practical purposes the tone of the policy and the guidance forward suggests no practical difference at least for the first year ahead. Thus the central tendency of RBI’s official CPI forecast for the year ahead is 8% (the same as Urjit Patel committee’s recommended target). It believes that the cumulative rate hike of 75 bps undertaken so far should be enough to achieve that outcome. However, it retains flexibility to act if this were to not be the case. In interactions subsequently, the Governor has reiterated his commitment saying that there is no trade-off between growth and inflation at this juncture since lower inflation is a pre-requisite for sustainable growth. He has also highlighted that cutting rates at this juncture will be quite meaningless since banks will anyway not be able to transmit the signal. This is a point we have been making all through last year (please refer “Can aggressive monetary easing create a funding problem in India?” dated 29th May 2013).
 
What Has Taper Done?
 
The possible implications of Fed tapering are already well documented by various commentators. However, we will recap briefly for sake of continuity of view. The period between 2009 and 2012 saw a surfeit of global liquidity courtesy aggressive balance sheet expansion by some of the largest central banks of the world. A significant portion of these flows came to EMs including India. For whatever reasons, many of these countries chose not to follow counter-cyclical policies to adjust for these flows. Thus in India both fiscal and monetary policy remained loose for very long which combined with policy issues created substantial structural imbalances over a period of time. These showed up as a persistent inflation problem along with steadily rising current account deficit even as growth began slowing. The important point is that as long as global investors were convinced that easy money was here to stay for the indefinite future (and this was precisely the case till early 2013), they were willing to overlook our deficiencies. The risk-free rate (proxy US treasury yield) to beat was low and money went everywhere chasing returns. However, with Fed taper in the air, global markets are finally having to come to terms with a scenario where sometime in the foreseeable new additions to global liquidity may come to a halt. This has forced investors to become much more discernable and all of a sudden countries with macro-economic deficiencies are no longer appearing to be as safe as before. This is what is happening since last year. Thus while there has been generalized EM aversion, specific countries have cropped up from time to time as being particularly distasteful. India’s turn came around mid of last year but our policy makers, much to their credit, have acted swiftly to drastically compress our current account deficit as well as ensure policy-induced capital flows. Thus in the current phase of EM aversion, the INR as remained remarkably stable.
 
What Does This Mean for RBI?
 
As mentioned above, the underlying current theme seems to be to punish EMs with macro-economic fragilities. The reprieve bought for us by policy makers via FCNR flows and compressing current account may be temporary. While there may be other cards on the table to get capital flows (global bond index inclusion being one), it is unlikely that they would be as significant as the USD 34 billion drive last year. On the current account, while the situation may remain manageable going forward, the extent of deficit is unlikely to be as low should gold curbs get relaxed or some economic growth leads to pick up in non-gold imports. It is clear then that if India needs to grow sustainably in the Brave New World where expectations are of diminishing incremental liquidity, we need to first put our macro-economic house in order or ‘bullet proof our balance-sheet’ as governor Rajan says. Apart from the twin deficits (current account and fiscal), the third integral part of our macro-economic report card is inflation. Thus the RBI’s current resolve comes timely and well in context of emerging global developments. Inflation of the order witnessed over the past two years (averaging 9.9%) may no longer be acceptable to global investors and hence may no longer suffice for macro stability. And without enduring macro stability there is no question of pursuing a sustainable growth agenda.
 
In our view, the dissenting voices lamenting the harsh monetary medicine in the face of weak growth are under-appreciating the new global paradigm. Assume for a moment that RBI cuts rate in the current environment and it gets transmitted as lower lending rate and adds to growth. This would quickly start pressing on inflation, current account and banks’ credit to deposit ratio. These will force adjustments in form of weaker currency and tighter rates (even if RBI doesn’t hike, market rates would adjust) which will quickly stall the recovery. Given this, we believe the RBI is right in first focusing on creating the conditions for growth before pushing actual growth. An important ingredient to this is obviously complementary government policy. A tighter fiscal situation involving better quality expenditure and policy focus to reform supply side can make the RBI’s job easier and more effective. However, till such complementary action becomes sustained, by definition the RBI will have to do most of the heavy-lifting. An additional uncertainty in this regard is that we are going into elections and the mandate on the other side is not so clear as of date.
 
How Should This Inform Our Market View?
 
If indeed average inflation falls from 9.9% to 8 – 8.5% this year as the RBI assesses and (barring new food shocks) we are inclined to believe, it would have ordinarily constituted as a very bullish trigger for rates and invited calls for cutting rates. However, if the new world order continues it may only count as a hygiene factor achieved. On the other hand, if new pressures were to emerge on inflation the RBI will have to act more proactively than before since the same world order will have that much lesser patience with our country. The implication for monetary policy in our view can best be summarized as ‘tighter for longer’. Most likely rates will be on hold at current levels for an extended period of time. At the same time, if new pressures threaten the inflation trajectory the RBI may show lesser patience than before irrespective of near term growth pressures. A large factor at play here will likely be how government policies evolve post elections. If they prove to be complementary, that may allow RBI to shift the burden somewhat. Alternatively, if the world order itself changes (US growth dips again and Fed changes track) that may make the central bank more tolerant.
 
From a portfolio strategy perspective, as we have highlighted many times before, seasonal triggers on rates have mattered more for bond fund performance over the past few years rather than one-directional movement on rates. As long as such seasonal triggers are captured effectively, it may not matter whether underlying RBI policy rates are static or marginally higher. More specifically in the current context, we have used the bond rally over the first half of January to cut duration in our bond and gilt funds. While lack of near term bond supply may keep yields in a range for now, the outlook may appear less favorable once new supply starts from April. Thus unless new triggers emerge (for instance if inflation falls more than expected in near term), we are likely to rotate into front end assets over the next months. This part of the curve is likely to do better from April on seasonal triggers of falling credit to deposit ratio and possibly better relative liquidity. Longer end rates may give clearer cues once market starts absorbing the new supply calendar and we get a better grip on how complementary government policies will be on the other side of the elections. By that time it will also get clearer whether this is indeed a Brave New World of shrinking incremental global liquidity or we relapse into potentially endless balance sheet expansion by global central banks.
 
Disclaimer:
 
MUTUAL FUND INVESTMENTS ARE SUBJECT TO MARKET RISKS, READ ALL SCHEME RELATED DOCUMENTS CAREFULLY.
 
The Disclosures of opinions/in house views/strategy incorporated herein is provided solely to enhance the transparency and should not be treated as endorsement of the views or as an investment advice. The information/recommendation provided is for informative purpose only and may have ceased to be current by the time it may reach the recipient, which should be taken into account before interpreting this document. The decision of the Investment Manager may not always be profitable, as such decisions are based on the prevailing market conditions and the understanding of the Investment Manager. Actual market movements may vary from the anticipated trends.This information is subject to change without any prior notice. The Company reserves the right to make modifications and alterations to this statement as may be required from time to time. This update has been prepared on the basis of information, which is already available in publicly accessible media or developed through analysis of IDFC Mutual Fund. Neither the IDFC Mutual Fund / IDFC AMC Trustee Co. Ltd./ IDFC Asset Management Co. Ltd nor IDFC, its Directors or representatives shall be liable for any damages whether direct or indirect, incidental, punitive special or consequential including lost revenue or lost profits that may arise from or in connection with the use of the information.

Tag:

Suyash Choudhary

The RBI surprised by hiking repo rate by 25 bps today to 8%. Correspondingly, the reverse repo and MSF rates have also been hiked to 7% and 9% respectively. All other rates were kept unchanged. The accompanying assessment shows continued subdued growth with fiscal tightening over Q3 and Q4 expected to further weaken aggregate demand. On inflation, while the central bank acknowledges the substantial fall owing to fall in fruits and vegetable prices, overall CPI still remains elevated. Furthermore, core CPI especially in respect of services is also high reflecting wage pressures and other second round effects. In fact, in context of inflation the RBI quotes several indicators that suggest that aggregated demand pressures are still contributing to inflation. These indicators include rising bank credit, increase in order book, pick up in capacity utilization and decline in inventory to sales. The assessment on the external situation is fairly benign with the current account deficit expected to be below 2.5% of GDP and with capital flows picking up. Furthermore, forex reserves have been built up and oil market companies are directly buying dollars from the interbank market. However, the sanguine assessment is succeeded with a caveat that both fiscal and monetary authorities need to continue efforts at macro stabilization.
 
The decision to hike rates is explained around two points. One, while headline inflation has fallen and may fall further, core CPI has remained flat and core WPI has in fact risen. Whereas, the condition mentioned in the last policy was for both the headline and core prints to fall. Two, the rate hike has been deemed necessary in context of protecting the RBI’s central forecast of CPI of 8% for the year ahead; a number also coinciding with the first year ‘target’ as mentioned in the Urjit Patel committee report. Importantly, further rate action will continue to be data dependent but if RBI’s baseline projections are met no further hikes in the near term are anticipated.
 
Assessment and Market Implication
 
In media interactions today, Rajan has been somewhat evasive with respect to upfront adopting Urjit Patel committee’s inflation targeting recommendation. More debate with relevant stakeholders like the government may be required to fully commit to the approach as well the numerical targets. However, given the flexible nature of the targeting recommended there may not be a world of difference at least over the next year or so between the approach now and what the committee proposes. Also in some sense, it may be argued that the RBI has already adopted at least the first year ‘target’ of 8% on CPI since the central bank explicitly mentions that the rate hike today will ‘set the economy securely on the recommended disinflationary path‘. While inflation in India is notoriously hard to predict given the large preponderance of volatile items, our own analysis points to a CPI range of 8 – 8.5% for the year ahead. This is of course not accounting for one time shocks like the one on vegetables over the past few months. Given this, it is likely that this was the last of the rate hikes for the foreseeable future. However, what is also true is that we will not look for rate cuts anytime soon.
 
The other significant aspect of the new RBI regime is the unwillingness to provide unlimited liquidity at the repo window. Thus while the caps on overnight borrowing were first introduced as part of the currency defense, the central bank has persisted with the restriction choosing instead to infuse additional liquidity via variable rate term repo. This approach has been reiterated by Mr. Rajan today. The endeavor will be to keep term repo cut-offs close to policy rate via active liquidity management. However, given that liquidity conditions keep evolving, it is reasonable to assume that the weighted average overnight rate may persist 10 – 15 bps higher than the repo rate; at least till liquidity deficits of the current order persist.
 
Bond yields have risen over last few days on overhang from Urjit Patel Committee recommendations combined with recent renewed emerging market fears. Although too soon to say, the latter seems to be abating now. Furthermore, market positioning is quite light and only two government bond auctions remain for the rest of the year. These should keep yields range-bound in the near term. However, market anxiety may pick up again towards start of the new auction supply calendar from April. Bullish triggers could emerge if next two inflation prints surprise even the current benign market expectations.
 
In terms of portfolio strategy, as mentioned in our last note we had been reducing portfolio maturity in our bond and gilt funds over the last month by switching away from long end bonds in favor of 5 – 7 year segment. Post the Urjit Patel committee report, we had started reducing overall participation as well by generating cash. We expect to continue this process over the next month and may look to gradually scale into shorter end assets. As mentioned before, bulk of bond fund returns over past 3 – 4 years have come via actively managing rate seasonality and not through structural fall in rates. We expect the same to happen in the year. In light of this, investors should continue with an asset allocation approach to such funds.
 
Disclaimer:
 
MUTUAL FUND INVESTMENTS ARE SUBJECT TO MARKET RISKS, READ ALL SCHEME RELATED DOCUMENTS CAREFULLY.
 
The Disclosures of opinions/in house views/strategy incorporated herein is provided solely to enhance the transparency and should not be treated as endorsement of the views or as an investment advice. The information/recommendation provided is for informative purpose only and may have ceased to be current by the time it may reach the recipient, which should be taken into account before interpreting this document. The decision of the Investment Manager may not always be profitable, as such decisions are based on the prevailing market conditions and the understanding of the Investment Manager. Actual market movements may vary from the anticipated trends. This information is subject to change without any prior notice. The Company reserves the right to make modifications and alterations to this statement as may be required from time to time. This update has been prepared on the basis of information, which is already available in publicly accessible media or developed through analysis of IDFC Mutual Fund. Neither IDFC Mutual Fund / IDFC AMC Trustee Co. Ltd./ IDFC Asset Management Co. Ltd nor IDFC, its Directors or representatives shall be liable for any damages whether direct or indirect, incidental, punitive special or consequential including lost revenue or lost profits that may arise from or in connection with the use of the information.

Tag:

Suyash Choudhary

The much anticipated Urjit Patel committee on monetary policy framework was released yesterday. Major points are summarized below:
 
1. Adopt headline CPI as nominal anchor for monetary policy framework. Target for CPI should be for it to fall from current 10% to 8% within 1 year and then to 6% within 2 years. Subsequently, the RBI should target CPI at 4% +/- 2%.
 
2. Since more than 57% of CPI is food and fuel on which direct influence of monetary policy is limited, the RBI will need to demonstrate commitment to the inflation anchor by responding to risks from second round effects and inflation expectations of shocks to food and fuel.
 
3. The institutional requirements for the new framework include government adhering to fiscal deficit targets (3% fiscal deficit by FY 17) and committing to eliminating administered setting of prices, wages, and interest rates. However, it is also recognized that not all pre-conditions may be fulfilled before the central bank moves to the new framework.
 
4. Monetary policy setting should be done via a monetary policy committee (MPC) including the RBI governor, deputy governor in charge of monetary policy, ED in charge of monetary policy, and two external members. The MPC should meet once every two months (but can meet more frequently if required). The committee will be held accountable for failure to meet the inflation target (defined as failure to achieve CPI of 4% +/- 2% for three successive quarters). In the event of failure, the MPC will have to issue a public statement stating reasons for failure, remedial actions proposed, and likely time period over which inflation will return to the centre of the target zone.
 
5. When inflation is higher than the nominal anchor, it is expected that ‘real’ policy rate will on an average be positive. The MPC could decide the extent to which it is positive, with due consideration to the state of output gap (actual relative to trend/potential output) and to financial stability.
 
6. Current monetary policy operating framework to be retired in phased manner. In the first phase, weighted average call rate will remain the operating target and repo will continue as the single policy rate. The MPC will vote to decide the repo rate and may even change the spread of LAF corridor (MSF and reverse repo rates at +/- 100 bps to repo as is the case currently). But the spread change should be as infrequent as possible. The cap on overnight repo at a percentage of net demand and time liabilities (NDTL) of banks should remain and RBI should increasingly provide more liquidity through variable rate term repos (14, 28, 56, and 84 day repos). In the second phase, as term repos gain acceptance, the policy rate voted on by the MPC should be a target for the short end of the money market, to be achieved through active liquidity management. The RBI will aim to keep 14 day term repo rate at or close to the target policy rate through liquidity management tools including two-way OMOs, fine-tuning repo/reverse repo liquidity management, and changes in CRR. The MSF rate should be made a truly penal rate to be accessed only under exceptional circumstances.
 
Interpretation
 
The recommendations of the committee are surprisingly bold and seek to replicate a format quite prevalent in many developed markets. Adopting an inflation targeting framework (even though the approach is still ‘flexible’)in the Indian context will require an order of policy discipline that has been seldom seen in the country so far. Not just that, the targets for headline CPI seem quite ambitious to say the least. To put this in context, we have index history on the combined CPI since January 2011 and therefore history of corresponding inflation (year-on-year change in index) since January 2012. During this almost two year period, there is just one reading below 8% for CPI. The average inflation during this period has been 9.9%. Even with the recent fall in food prices, it is quite unlikely that CPI falls below 8 – 8.5% on an average over the next 12 months; let alone comply with the future targets of 6% and then lower. A lot of complimentary action needs to be taken on fiscal deficit and supply side reforms, most of which is outside the ambit of the RBI, for these kind of inflation levels to become a reality. However, while the committee acknowledges the need for this complimentary action, it nevertheless believes that the policy framework should be adopted even if all pre-conditions have not been met. Doing this will put a lot of onus on the central bank and its credibility since, even though recent actions from the government including on fiscal deficit compression have been positive, large structural reforms from the government will have to wait at least till the elections are over. Even then, the effects of such actions will only show in inflation with a substantial lag. In the mean time, the RBI will have to shoulder accountability with respect to these ambitious inflation targets.
 
Implications
 
We would be inclined not to take this report very seriously had it not been commissioned explicitly (and referred to on multiple occasions) by the RBI Governor himself. Indeed, clarifying the monetary policy framework is one of the central pillars that Rajan has been mentioning since taking office. Further contributing to its sanctity is the fact that the Deputy Governor in charge of monetary policy has chaired the committee. While we still believe that implementation may take some time and the report may not necessarily get accepted in its entirety, given its credentials and its context, we have to consider the implications with respect to its impact on the monetary policy reaction function. Notwithstanding recent murmurs of rate cuts on the back of falling inflation, it has been our long standing view that there is little scope in India for a rate easing cycle given its macro-economic imbalances. This view may gain generalized acceptance, despite CPI inflation falling towards 8 – 8.5% over next few readings, should the recommendations of the committee get accepted. Hence falling inflation which was hitherto a large bullish trigger for bonds, may cease to be so if the market starts to believe that the central bank is explicitly targeting an inflation rate that is even lower. Even so the near term demand –supply dynamics for bonds remains quite favorable given that the auction supply for this financial year is almost over and the fact that the RBI has recently shown renewed propensity to plug liquidity deficits via OMOs. This may cause yields to remain in a range or even rally further on bond supply cues, market positioning etc. However, a larger near term rally would be predicted on a explicit assurance that the committee’s recommendations are not likely to be adopted anytime soon. Furthermore, and given our view that India doesn’t have room for rate cuts, the bond rally will anyway stall ahead of the fresh supply due from April. Given the large maturities of government bonds due next year (INR 168,000 crores more than half of which is due in April and May), it is likely that weekly bond supply starting April will be sizeable.
 
Portfolio Strategy
 
We have been running an aggressive allocation towards government bonds in our bond funds (income, dynamic, and gilt funds) over the past few months. This has been on expectation that much of the outlier macro-economic risks for India are over and that market fears of serial rate hikes from RBI are misplaced. This strategy has been well rewarded in a sharp rally over the past month. We have used this rally to gradually reduce portfolio maturities by switching away from long end bonds in favor of shorter tenor ones while keeping overall government bond participation broadly unchanged. However, given the triggers detailed above we find merit in gradually reducing overall participation as well from this point on. In doing so we are fully cognizant of the fact that we may not fully participate in the next 20 -25 bps rally should it occur. However the decision is premised on a view that the risk-reward, while still favorable owing to lack of bond supply, will progressively be less so over the next couple of months. Also for reasons mentioned above (to which political uncertainty ahead may perhaps be added), we don’t see a secular move on rates ahead. This will be even more so should the RBI move towards accepting the Urjit Patel committee’s recommendations.
 
Investors should consider bond funds from an asset allocation perspective of 18 months to 2 years and preferably not use them tactically to capture short term market moves. It should also be remembered that most excess returns over past 4 years have been captured not when rates were in a secular bull run but by simply playing seasonal triggers. The same format is likely to persist in the time ahead as well even though the triggers affecting bond performance may change again. That be the case, a view that RBI will not cut rates should NOT BE construed as a recommendation to exit bond funds.
 
Disclaimer:
 
MUTUAL FUND INVESTMENTS ARE SUBJECT TO MARKET RISKS, READ ALL SCHEME RELATED DOCUMENTS CAREFULLY.
 
The Disclosures of opinions/in house views/strategy incorporated herein is provided solely to enhance the transparency and should not be treated as endorsement of the views or as an investment advice. The information/recommendation provided is for informative purpose only and may have ceased to be current by the time it may reach the recipient, which should be taken into account before interpreting this document. The decision of the Investment Manager may not always be profitable, as such decisions are based on the prevailing market conditions and the understanding of the Investment Manager. Actual market movements may vary from the anticipated trends.This information is subject to change without any prior notice. The Company reserves the right to make modifications and alterations to this statement as may be required from time to time. This update has been prepared on the basis of information, which is already available in publicly accessible media or developed through analysis of IDFC Mutual Fund. Neither the IDFC Mutual Fund / IDFC AMC Trustee Co. Ltd./ IDFC Asset Management Co. Ltd nor IDFC, its Directors or representatives shall be liable for any damages whether direct or indirect, incidental, punitive special or consequential including lost revenue or lost profits that may arise from or in connection with the use of the information.

Tag:

admin

What are the most important things to do in January? Yes making resolutions is one important thing most of us do. But something that’s not just important but also urgent that must be done in January is to prepare yourself for filing your tax return in March.
 
Now before you do that, it’s important to know the standard deductions and allowances that can help you save some tax.
 
One of the key allowances that most of us forget to use is leave travel allowance or LTA.
 
In simple words, LTA is the entitlement – a monetary allowance – you receive from your employer to go on a vacation.
 
In this article, we explain the basics of LTA and how you can claim the same.
 
First, who is included in LTA?
To claim LTA from your employer, you must travel alone or with your dependent family, which may include your spouse, parents, siblings and children.
 
Now, you cannot claim LTA if your family travels without you, because the law specifies that you should be travelling as well.
 
What is covered in LTA?
Only your travel costs are covered under LTA. So you cannot splurge money on eating and partying or hotel bills and then try to claim that from your employer.
 
Whether you fly, take a train or any other public transport during your travel, you can show the ticket and claim your LTA. As far as car travel is concerned, the cost of travel only by cars from central government organisation like ITDC, the state government or the local body, is permitted under LTA.
 
If you could not get public transport and resorted to private transport, try and get a bill. If your employer does not accept the bill, you can always file an income tax return, claim an exemption and get a refund.
 
Always remember to keep your travel proof in the form of bus, air and rail tickets handy as they will be needed by your employer.
 
Finally, you can claim LTA for only domestic trips (within India), and not any international trips.
 
How often can you claim LTA?
You can do that twice in a block of four calendar years.
 
By the way, LTA is not related to when you started your employment with a company. The government fixes blocks of years, and you have to abide by those rules.
 
Also, while you can get a tax exemption for two journeys in a block of four calendar years, you can do that for just one time in a particular year.
 
What if you don’t claim LTA?
Well, in that case, the amount of LTA claim would get added to your salary, and you would be taxed on it.
 
Now what are you waiting for? Go and catch that airplane or hop onto a train or bus to take your next vacation.
 
A holiday would not just do a world of good for your health, but can also help you save some tax.
 
Mutual Fund Investments are subject to market risks, read scheme related documents carefully.
 
The information set out herein is for general purposes only. The information set out is neither a complete disclosure of every material fact of the Income-tax Act, 1961 and/or income tax rules, nor does constitutes tax or legal advice. Investors should be aware that the fiscal rules/ tax laws may change and there can be no guarantee that the current tax position may continue indefinitely. In view of the individual nature of the tax consequences, each investor is advised to consult his/ her own professional tax advisor. Investors alone shall be fully responsible / liable for any decision taken on the basis of this document. Neither IDFC Mutual Fund/IDFC Asset Management Company Limited nor any person/institution connected with it accepts any liability arising from the use of this information.

Tag:

admin

IDFC Equity Opportunity – Series 2 Fund Manager – Punam Sharma speaks on why companies with operating leverage will benefit in better times.

Tag:

admin

When the customer walks in

By: Punam Sharma

If you have borrowed money in the past or have invested in companies that borrow money, you may be familiar with the term ‘financial leverage’. Financial leverage, expressed as the ratio of debt to equity refers to the magnitude that a business is financed by debt (borrowings) versus equity (owner’s funds). The more debt, the greater is the financial leverage.
 
Another very important concept related to leverage that is less-known is ‘operating leverage’.
 
In simple words, operating leverage measures a company’s fixed versus variable costs.
 
Let’s take an everyday example.
 
Assume that you open a restaurant in the outskirts of your city, which is currently thinly populated, but you expect a lot of people to inhabit the place in the future and thus demand for food to increase. Here are your monthly costs of running the store –
 
• Cost of raw fruits and vegetables – Rs 1,000
• Cost of electricity, air-conditioning etc. – Rs 100
• Cost of employees – Rs 100
• Your salary – Rs 50
 
Thus, adding up all these, the average total costs come to Rs 1,250.
 
Now, if you sell around Rs 1,500 worth of food during a month, your net profit is Rs 250. So, your net margin is Rs 250 divided by Rs 1,250, or 20%.
 
Now assume that more people do come and stay in that locality over a period of time, and more people eat at your restaurant thus leading to an increased monthly income of Rs 2,500, here is how your profit statement would look like –
 
• Income – Rs 2,500
• Cost of raw fruits and vegetables – Rs 1,200 (this will increase slightly as more people eat)
• Cost of electricity, air-conditioning etc. – Rs 100 (this will remain the same as you have to maintain lighting and air-conditioning in a restaurant whether there are less or more customers)
• Cost of employees – Rs 100 (this will also remain the same)
• Your salary – Rs 50 (this will remain the same)
• Total costs = 1,450
• Net profit = Rs 2,500 – 1,450 = Rs 1,050
 
Your net margin now is Rs 1,050 divided by Rs 2,500, or 40%.
 
In all, you are now making more profit for every rupee of food sold.
 
This is what operating leverage is all about.
 
The greater proportion of fixed costs (costs that don’t change much with change in the level of business), the greater the operating leverage.
 
Like financial leverage, operating leverage magnifies results, making gains look better and losses look worse.
 
In bad times, when the overall business environment is bad and stock markets are punishing companies that are facing bad times – weak demand, low profits – it pays to identify businesses that have operating leverage – whose profits can jump up with even a small revival in demand for their products or services.
 
In these current times, we see a lot of companies facing…
 
• Poor economic environment and hence low capacity utilisation
• Poor demand leading to low pricing
• Low profitability and low return on equity
• Stretched balance sheets
• Poor cash flows
 
Thus, as an investor, if you can identify the ones with high operating leverage, and which are managed by sensible people but are only facing a bad business environment, and if you get an opportunity of picking them up at the right prices, there is a decent probability that you would earn good returns on them when the tide turns for the better.

Tag:

IDFC Mutual Fund

 
The year 2013 was characterized by an improving demand environment in the developed economies versus deteriorating demand environment in the developing economies. While the developed world strived to bring back inflation the emerging world had to struggle reigning in Inflation forcing them to increase rates even in a low growth environment. Current account vulnerabilities of the emerging economies came to the fore midyear in response to the QE tapering talks manifesting itself in extreme currency weakness across the emerging market pack. In this backdrop developed economies and sectors aligned to global growth performed better in contrast to sectors with domestic underpinning.
 
Chart – I – Performance of Sectoral Indices – YTD
 

 
Source: Bloomberg
 
Policy inaction, regulatory hurdles, high cost of doing business and poor credit cycle
 
Beneficiaries of external demand environment and weak domestic macro
 
Chart – II – MSCI world index (MSDUWI) vs MSCI emerging market (MXEF) Index
 

 
Source: Bloomberg
 
Divergences in sectoral performances were huge across quarters as markets completely shunned sectors linked to the domestic demand and macro environment in favor of the more globally aligned sectors…
 

Name 31-Dec-13 30-Sep-13 28-Jun-13 28-Mar-13
NIFTY INDEX 6304 5735.3 5842.2 5682.55
CHANGE (%) 9.9% -1.8% 2.8% -3.8%
FII flows cumulative YTD- USD Bn 19.92 13.40 13.34 10.15
FII FOR THE QUARTER – USD Bn 6.52 0.06 3.19 10.15
 
Divergence of  best &  worst index 37.15% 45.66% 25.57% 41.16%

 
Source: Bloomberg
 
For India 2013 was a year where twin deficits led to disruptive moves on currency, interest rate and domestic liquidity which strained the cost of doing business as well as the incentive for incremental capital expenditure. The deteriorating credit cycle in the investment part of the economy has made Banks and Financial Institutions wary of incremental credit and the covenants imposed for incremental credit further increase the cost of doing business in India.
 
Chart – III – INR movement – YTD
 

 
YTD Currency depreciated by 12.5% . Touched a low of 68 (25% depreciation) before stabilizing
 
Chart – IV – Yield curve – 31-12-2012 vs 31-12-2013
 

 
Yield curve shifted upwards by 100 bps rendering spread unattractive for incremental capex
 
Source: Bloomberg
 
For the corporate sector in India thus, underlying growth and margin drivers got tested across sectors
 
Consumption – The stressed fiscal situation and rating downgrade overhang has restrained the government’s capital commitment towards un -productive subsidies leading to demand destruction in products / businesses whose model was predicated on continued fiscal profligacy. However good Monsoons and a robust harvest has helped rural India and augured rural spending.
– Diesel prices have gone up by around Rs. 7 in this year
– Pricing power and volume growth was impacted for the consumer part of the economy.
– High valuation
– Companies with a good rural franchise and products suited to capture share of the rural wallet benefited across categories
 
Banking and Financial services – Monetary policy intervention in response to the possibility of an early QE taper led to an environment of extremely tight liquidity and weak currency.
– Rising import costs because of INR depreciation put pressure on profitability of the corporate sectors (High import content) in an already weak growth environment
– Rising interest rates and tight liquidity accentuated the working capital put a lot of stress on the corporate sector further deteriorating profitability for them and credit cycle for the banking and financial services space.
 
Exporters – Modest growth recovery in the external sector and INR depreciation acted as catalyst for exporters. The improving fundamentals clearly got rewarded and this was by far the best performing sector across the year.
Investment – Social underpinning and policy inertia of the current political establishment has throttled growth in investment part of the universe
– Low capacity utilization leading to sub optimal ROE ,
– No incentive for fresh capex as current ROE does not cover for the business risk premia in an environment of high interest rates
 
Summary
 
Growth post the GFC (Global Financial Crisis) has been driven by easy monetary and fiscal policies trying to spur demand and avoid recession across the globe. There has been an unprecedented and unsustainable increase in both central banks and government balance sheets forcing a re-think. Across developed and developing economies policy makers are embarking on a journey of self sustaining growth models slowly withdrawing easy credit and shifting focus to structural reforms to promulgate an environment where stress is to enhance productivity and capital efficiency rather than relentless capacity expansion and growth. The year 2014 will see a phase of consolidation in balance sheets across central banks, governments and corporate sector as this transition takes place.
 
In this environment our investment focus for 2014 will be that of conformity to the above macro construct of modest growth, tighter capital conditions (cost and availability) and waning fiscal support. As we had written in our earlier note “India may not be a growth economy but higher profitability is what is required to revive the environment. We have the capacities, now we have to find the profitability”. Further the deteriorating return ratios are a precursor of consolidation and return of pricing power in any economy as inefficiencies get cut in the system.
 
Margin of safety today lies in orienting portfolios towards companies which have the balance sheet strength (low leverage) and operating matrix strength (pricing power, cost structure, business franchise) to navigate this transitory period. These set of capital efficient companies (by virtue of their superior operating matrix supporting profitability and superior balance sheet) will be the consolidators in the environment where macro induced mortality risk will be high.
 
The survivors we believe will have a disproportionate share in the underlying profit pools.
 
Elections in India are a big variable and the outcome of the same will incrementally guide the capital allocation of both the government and the private sector. The recent legislative elections verdict dismissed the current socially oriented political establishment in totality providing some insights into the voter’s leaning….
 
Wish you all a very happy new year and a great year ahead!
 
Disclaimer:
 
MUTUAL FUND INVESTMENTS ARE SUBJECT TO MARKET RISKS, READ ALL SCHEME RELATED DOCUMENTS CAREFULLY.
 
The Disclosures of opinions/in house views/strategy incorporated herein is provided solely to enhance the transparency and should not be treated as endorsement of the views or as an investment advice. The information/recommendation provided is for informative purpose only and may have ceased to be current by the time it may reach the recipient, which should be taken into account before interpreting this document. The decision of the Investment Manager may not always be profitable, as such decisions are based on the prevailing market conditions and the understanding of the Investment Manager. Actual market movements may vary from the anticipated trends. This information is subject to change without any prior notice. The Company reserves the right to make modifications and alterations to this statement as may be required from time to time. This update has been prepared on the basis of information, which is already available in publicly accessible media or developed through analysis of IDFC Mutual Fund. Neither IDFC Mutual Fund / IDFC AMC Trustee Co. Ltd./ IDFC Asset Management Co. Ltd nor IDFC, its Directors or representatives shall be liable for any damages whether direct or indirect, incidental, punitive special or consequential including lost revenue or lost profits that may arise from or in connection with the use of the information.

Tag:

Suyash Choudhary

2013 turned out to be a wild ride for financial markets generally, and bond markets particularly. The year witnessed the highest levels of volatility in bond yields in the last 4 years. Taking the 10 year government bond yield as benchmark, the year started at 8%, saw a low of almost 7% and then a high of almost 9.5% ; before cooling off somewhat towards year end. As this exceptional year comes to a close, this is as good a time as any to summarize the triggers that defined the bond market and takeaways that we learned from these.
 
A bond market summary of 2013
 
The year started on a sanguine note with market looking forward to RBI easing policy rates. This expectation along with usual year end Open Market Operation (OMO) bond purchases by the central bank ensured that bullish sentiment dominated resulting in bond yields falling by 20 bps during the first 2 months of the calendar year. Indeed the RBI delivered on the rate cuts expected but with important caveats around the limited room available for the same. However, as inflation started turning lower, market chose to ignore the RBI’s guidance and expectations of future rate cuts started building up. Ironically, these expectations sustained in the face of stark vulnerabilities on the external account; a risk that RBI was highlighting at the time although the effect of this commentary was getting somewhat diluted by the accompanying rate cuts.
 
The Fed Chairman Bernanke drove this point perhaps more forcefully by flagging in late May the possibility that the Fed may taper its bond purchase program in the time ahead. This broke the momentum in domestic bonds and yields started to drift higher. The rupee also headed weaker, towards the 60 mark, as investors started punishing emerging markets with high current account deficits and FII outflows commenced. Even so the bond market was ill prepared for the shocker that the RBI delivered in mid-July by effectively resetting overnight rate higher by 300 bps. This was a classic interest rate defense for the currency, intended to sharply hike carry cost for the rupee and hence discourage speculative intent. The fact that the RBI was willing to do so even in such a weak growth environment was intended to further signal strong commitment. However, the rupee’s woes continued to intensify as, on the one hand, investor out-flows continued while on the other India’s high current account deficit ensured strong monthly demand for dollars from local entities. This simple demand-supply mismatch ensured that the currency touched almost 69 to the dollar at its weakest.
 
Through this first phase starting mid-July, the yield curve was massively inverted with the overnight funding rate being more than 150 bps higher than even long tenor government bonds. However, market’s appetite to buy duration was still reasonable since investors had space to buy and policy-makers were guiding that this phase was temporary. Furthermore, there was also guidance that the intent was not to unduly affect long end yields. In fact, the central bank did bond buy-backs from time to time during this phase to protect bond yields and even allowed valuation flexibility to banks in order to protect them from mark-to-market losses which were judged to be temporary. During this phase, episodes of market break-down when yields spiked were triggered by fears that policy was losing grip over the rupee. However, most participants believed that if and when policymakers put together a credible source of dollar supply, the rupee’s woes will subside and by implications bond yields would soften as well since the RBI would have no reason then to continue to with its interest rate defense. Indeed commentary from the RBI seemed to support this view with the central bank saying in its July policy review that its bias would be to continue easing monetary policy had it not been for the currency volatility. Options like NRI deposit and / or sovereign bonds used to get discussed by the market at that time as possible solutions to get meaningful dollar flows.
 
The second phase for bonds started with the change at RBI’s helm in the form of the new Governor Rajan. The central bank announced dollar garnering measures via incentivizing FCNR deposit mobilization by offering discounted hedge and SLR/CRR exemptions. Furthermore, it relaxed limits on offshore debt raising by banks and also provided discounted hedges for the same. These moves constituted a credible source of enhancing dollar supply to the market. Whereas on the demand side, measures to address Oil Marketing Companies’ (OMC) dollar demand directly from the central bank, curbing gold imports, as well as generalized import slowdown on the back of weaker growth, all served to sharply reduce demand for dollars from the currency market. Cumulatively, the above measures changed the demand versus supply equation for the rupee drastically and reversed the currency’s fortunes. This resulted in a sharp appreciation of the rupee and the relative stability sustained even as Fed tapering fears came back with renewed detriment to some other emerging market currencies like that of Indonesia. Given the strong linkage between expected bond performance and currency witnessed in the first phase, this change should have triggered a bond market rally. However, Governor Rajan changed the rules of the game somewhat by hiking the repo rate even as he moved to restore normalcy to the LAF corridor by also simultaneously cutting the MSF rate. While on net policy was eased, a fact that the RBI Governor took pains to highlight to the market, there was a large signaling effect of the repo rate since it represented a change in direction of monetary policy. Also, contrary to policy guidance so far (including from Mr. Rajan himself in his earlier avatar with the government), market could no longer consider the interest rate defense as temporary so long as future repo rate hikes still remained on the table. To further spook the market, inflation started taking a turn for the worse thereby further cementing expectations that there may be further repo rate hikes. Governor Rajan’s commentary centering around anchoring inflation only added to the fears. There were a few interventions from the RBI to soothe market fears and arrest bond yields, including via OMOs as well as verbal clarifications. However, these lacked consistency and could not measure up to the general lack of risk appetite in the market. What further dented appetite was the fact that even with currency stabilizing, the RBI kept the caps on repo borrowing alive choosing instead to infuse additional liquidity via term repo in a bid to develop a term structure for interbank money market rates. While no doubt a good development initiative, this again was counter to earlier policy guidance that the measures instituted in mid-July were ‘temporary’; since the earlier regime included no such artificial caps on overnight borrowings. The same has ensured that average overnight rate has been very volatile depending upon liquidity in the system and not necessarily anchored to the repo rate (which was the case in the earlier regime). Finally, with the FCNR and banking debt flows printing almost USD 35 billion, far in excess of expectations and contributing both to RBI’s reserves as well as rupee liquidity, expectations of the central bank conducting OMOs to infuse liquidity have abated. All told, the year ends with a scenario quite different from what was the case in the first phase of the interest rate defense. Unlike then, now bonds are no longer ‘negative carry’ as the overnight rate (even though not anchored to the repo rate) is lower than most of the bond curve. However, uncertainty with respect to RBI policy has increased substantially under the new regime while risk appetites of investors have been dented significantly over the last few months. Given these factor, incremental improvement in macro-triggers have underwhelmed the market as demonstrated in recent price action.
 
Our key takeaways from 2013
 
Like the year gone by, any period of change-over throws up significant learning for the market. The learning from the last great bond disruption in 2009 was that changes to bond supply can significantly change price action even if monetary policy is held constant. It may be remembered during the early part of that year a massive bond rally was stalled simply because government borrowing increased on account of a higher fiscal deficit, even as monetary policy remained very accommodative. In fact, similar dynamics prevailed till 2012, insofar that bond performance was often divorced from the direction or level of RBI’s policy rates. This is because the RBI adopted OMOs as a central tool for infusing primary liquidity (in absence of rise in foreign exchange reserves creating liquidity). Also, given the seasonal pattern of liquidity, most of these OMOs used to be back ended towards the last 4 – 5 months of the financial year; coinciding almost perfectly with the government’s auction supply tapering off. Hence, the net supply of bonds used to reduce significantly over the last few months thereby triggering a year-end rally for bonds. This constituted a predictable seasonality on rates, one which actively managed bond funds have benefited from to a large extent.
 
2013 offered significant and multiple lessons. The very first for us was amidst the massive rally between April and May where falling inflation prints and renewed expected easing dominated, irrespective of very visible external account concerns, heavy bond supply, and RBI’s muted forward guidance. The rally did not sit well with our overall macro-economic framework and so we chose to participate cautiously. In hindsight, we were proven right and were thankful for it. However, the learning from the phase was this: at the peak of that phase when 10 year yields were hovering around 7.20%- 7.25%, not many had an expectation of below 6.9% or so. Even had that expectation fructified and assuming most would have succeeded in selling precisely at the bottom of their expected range, even then the gross return for the year would have been approximately 9.25%. Note that this would have been the most optimistic estimate and the truth would have been somewhere in between. In contrast, lower risk accrual assets were delivering 8 – 8.5%. Unfortunately, this phase also coincided with a sharp build up in long term bond fund assets. While all this analysis undoubtedly has the benefit of hindsight, the first key learning that got reiterated to us was: when deciding upon investment strategies, adjust participation in line with pay-offs. This is often a difficult call and needs to be done at the peak of market momentum, as was the case in April and May as well.
 
During the first phase of the interest rate defense starting mid-July, all levels of policy makers had taken pains to assure the market that the intent wasn’t to unduly impact long term bond yields. This seemed logical since an effective 300 bps interest rate shock had been delivered overnight in an environment of already weak underlying growth. Also, it was assured time and again that the phase was temporary. The framework then seemed straightforward: the interest rate defense had led to long end yields rising as well by about 100 bps, thereby (in our judgment) adequately compensating us for the underlying macro-economic environment. At some juncture as rupee stability was achieved the exceptional measures would be unwound and market would go back to the earlier framework of operative rate being the repo rate. At that juncture, bond yields would have a strong incentive to come off (although certainly not in the neighborhood of where they had been in April – June). This framework was reaffirmed by RBI’s moves to alleviate banks’ investment book pain and their accompanying assessment that the losses may be temporary, as well as by the first quarter policy review where the central bank displayed an underlying bias to be cutting rates. Most of this phase was one of waiting and watching since, as we have recapped above, India struggled to find a credible source of dollar flows for these first few months. Whenever the source materialized, the other triggers would have fallen in place. However, and not withstanding earlier guidance, the RBI policy framework kept evolving as well. This was largely on account of a Governor change but also partly due to inflation reversing course. With the first repo rate hike, the earlier guidance and framework were effectively revoked. However, Mr. Rajan also seemed reluctant to let bond yields rise significantly announcing OMO to plug the rise and considering the rise in bond yields as indicative of liquidity tightness which could hamper credit to productive sectors or the economy. This seemed consistent with the earlier RBI regime and also suggested that Mr.Rajan may not follow a substantially tighter policy. While the Governor’s interest rate stance has evolved quite consistently and along the lines we had anticipated, the interventions to plug bond yield rise have been quite ad-hoc and have frustrated the market. The second key learning, or more accurately an observation, was: policy guidance is obviously free to continue evolving in times of uncertainty; however during periods of such evolution it can unintentionally enhance the financial market volatility that it is in fact attempting to contain.
 
In the October policy, while he hiked repo rate again, Mr.Rajan nevertheless sounded somewhat dovish with respect to the future. While inflation remained the primary concern, the context of weak growth was very much recognized and the RBI seemed comfortable with the level of rates after this hike given their forward inflation projections. This interpretation was reaffirmed when Mr.Rajan intervened in November after an ugly headline CPI print to assure the market that the central bank was concerned about the weak economy as well as high inflation. He has remained consistent with the framework in December as well where, much against consensus expectations, he chose to keep rates status quo willing to wait and see how much of the recent spike in inflation proves durable. Coming out of the October policy, market’s view on rates was fairly sanguine. The RBI did not seem too keen to hike rates further and overnight rates had been restored to 8.75% or lower. The only problem was relatively heavy bond supply over November. However, given underlying triggers, it was believed that yields should not rise by more than 15 – 20 bps because of this supply. On the other hand imponderable bullish triggers remained as well, including the possibility of some progress on India’s inclusion in global bond indices. The only risk market envisaged was a fresh episode of currency weakness. However, even though the rupee remained well behaved during this phase, bond yields continued to rise. Even the expiry of the heavy supply period did not change sentiment and the grind up in yields continued. The proximate causes were these: One, higher than anticipated dollar inflows negated market’s OMO expectation. Two, rumors resurfaced that the RBI will go ahead with the government’s bond switching program (under which it will buy back short term bonds and issue longer term bonds from market). Three, inflation numbers received in December posted a shocker on the back of sustained rise in vegetable prices. Whatever the proximate causes, the underlying theme was that market’s risk appetite had been significantly dented and hence participants required a much more visible and emphatic trigger than the ones that were in place. This, then, threw up the third learning: the market’s willingness to react to positive triggers is determined by its propensity at the time. If recent experience of risk appetite has been negative, the strength of the trigger has to be proportionately higher.
 
Investor implications
 
Understandably, 2013 is a year that most bond fund investors would like to put behind them. It is also quite natural that recent experience would weigh on future investment decisions as well. However, it must also be remembered that the order of volatility (cumulatively of 300 – 350 bps) witnessed this year is truly exceptional and strikes only in very rare years. This episode represented a rude expectations’ readjustment for global financial markets away from what was till very recently being perceived as an indefinitely long period of very easy money. Within the context of this adjustment, some emerging market nations like India stood out as very vulnerable, courtesy implications of policies followed over last 4 years. Hence, the adjustment for India had to be even more rapid and painful. However, now most of the first round of adjustment is done and at least on the external front, where we were the most vulnerable, it has been truly remarkable. Our current account deficit this year will be only 60% of last year and we have also managed to shore up our foreign exchange reserves. What remain are domestic adjustments chiefly on inflation and fiscal deficit. In the meanwhile we are broadly left with a currency which is weaker than before and interest rates which are higher than before. The future direction of each of these market variables will depend largely upon how rapidly and credibly we can tackle our inflation and fiscal deficit. If this assessment rings true, it has the following takeaways for investors:
 
Future investment decisions should not be based on the experience of 2013. The extent of bond market volatility has been truly exceptional this year and is unlikely to get repeated now that a large part of India’s macro-economic adjustment to the new reality is already done or is well under-way. In all likelihood, market will go back to a much narrower range reacting to incremental triggers on macro-policy, inflation and fiscal deficit / bond supply. However, what is also true is that some investors would reassess their appetite for the trade-off between risk / volatility and expected pay-offs more closely, and possibly decide to settle for a more conservative trade-off. While doing so, it is important not to over-compensate one set of risk (interest rate risk) with another (most likely credit risk). Other investors may remain with an asset allocation approach to bond funds. This also is a prudent approach since the market will likely throw up as many opportunities for active managers in the years ahead as in the years before, but possibly with new triggers determining the short term direction of rates.

Tag: