By: Punam Sharma
The last few days have been epochal for India, delivering a landmark election result and buoying the hopes and dreams of many. Amongst these many one can definitely count financial markets, which are already looking forward to an era of stronger financial stability, lower inflation, and better growth. While equities and currency were already getting the good feeling for some-time, bonds have also joined in over the past few weeks. We assess here our view on the evolving environment and portfolio strategies.
The Great Adjustment Continues
In our view, the best way to visualize incremental developments is in context of the much needed macro-economic adjustment that had started last July and is on-going. We have spoken on many occasions before on what was wrong and hence will only summarize it here. Amongst other things, a combination of very low real interest rates and continual erosion in capital productivity had landed us in a situation of high inflation, high current account deficit, and high banking credit to deposit; but with very low growth. When the US Fed threatened to stop the music of infinitely growing liquidity, we had to make very quick and harsh adjustments. However, a more sustained and longer term adjustment had to rest with a consistent framework for monetary policy that would anchor inflation expectations and hence address the issue of savings erosion, and a strong government focus to enhance productivity and help with lowering inflation and expectations via supply side reforms, policy clearances, and fiscal consolidation.
With Governor Rajan and the clarified monetary policy framework anchored around CPI inflation, the first leg of the framework has been firmly in place for some time. The second leg, involving strong focus from the government, has been reluctant to fall in place thus far. Were this to continue, the RBI would have to continue to do the heavy-lifting in order to ensure steady disinflation and ultimate achievement of sustained macro-financial stability. However, with the election handing over a decisive mandate to a pro-reform agenda, there is now hope that the government will shoulder its fair share and hence allow the RBI to be more measured while still achieving the desired rate of disinflation.
Our portfolio strategy is evolving in line with our observation of how the adjustment process is progressing. We had started to build back some duration in April (please refer ” A Macro and Bond Market Recap” dated 29th April for details). As prospects of the adjustment process progressing have continued improving, we have continued adding to duration. At this juncture, we have a strongly overweight position in 5 – 9 year in our bond and gilt funds. We assess that demand versus supply dynamics are stronger for this part of the curve currently given lower net supply (versus longer maturity segments), stronger FII interest (they typically prefer this segment to longer end), and the still relatively flat yield curve (and hence better perceived risk versus reward).
Besides the more macro-level monitoring of how the adjustment process evolves from here, there are 2 micro-level triggers that we will be watching for and that are likely to inform any changes to our portfolio strategies going forward:
1. Whether RBI takes incremental steps to influence the overnight rate setting: We think that from a policy rate setting perspective, the RBI is likely to be on a long pause provided it is comfortable that government steps will aid the disinflation process. However, besides the setting of repo rate the RBI can also influence the overnight rate through its variety of liquidity management / access tools. Thus for instance, while it kept rates unchanged in the last policy, it further restricted access to overnight window thereby implicitly hiking cost of funds. Average overnight setting will in turn determine the ‘term premium’ for bonds and hence their relative attractiveness.
2. Net supply absorption including whether the full year budget adds to supply: As we have highlighted before, net supply of bonds picks up substantially from here as the next large bond maturities now are in October and November. Furthermore, while the focus of the new government may still be on fiscal consolidation, they may want to make the starting point more credible via a one-time upward adjustment to the interim budget’s 4.1% fiscal deficit target. This may entail additional supply of bonds.
What Should Investors Do?
While we adjust portfolio strategies based on new developments to our macro framework, investors should assess risk appetite and accordingly add / maintain bond fund allocations. At some juncture, when it becomes apparent that the great adjustment is progressing well, such allocations are likely to be well rewarded since real market yields will look attractive then. Assessment of risk appetite is important because if the adjustment process runs longer than market currently anticipates, investors need to be able to weather the volatility. The choice of investment strategy is also important here since market may swing from focusing on risk (as what happened over second half of last financial year) to focusing on reward (seems to be happening over past month, and happened strongly over April – June last year), and then back again. Over the longer term the best investment is that which optimizes reward adjusted for risk. In this context, we would caution against ‘perma-bull’ strategies that may look good on hindsight but are difficult to allocate to for the future. In our view, such strategies would have under-appreciated the new RBI framework as well as the potential risks from an unfavorable election outcome that could have drastically stretched the adjustment process, but may be looking good now owing to a fortuitous turn of events. However, should the market start refocusing on risk at some point in the future, such strategies are likely to amplify the volatility faced by investors.
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