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Investment Insights

Suyash Choudhary

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.
 
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.

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The verdict is an absolute majority for the BJP led NDA! The formation of the Government will be a mere formality. The markets have given thumbs up to this majority (after 30 years, since the 1984 elections, a single party has been able to cross the half way mark). This puts a lot of uncertainty out of the way and with this mandate the Government would be able to assert changes in the policy and make it more productive.
 
What has been wrong with the current economic cycle?
The current Indian economic cycle has been marked with some deficiencies, in our view:
 
A fall in financial savings to GDP: This in turn has been manifested in a persistently high credit to deposit ratio with banks even at a cyclically low level of GDP. Partly because of this, transmission of RBI policy rates to banks’ lending and deposit rates has been weak. The other manifestation has been in a steadily rising current account deficit at least up until last year. Any cyclical uptick in investments may put upward pressure on the current account unless savings also simultaneously pick up.
 
A steady deterioration in capital efficiency: The other hallmark of this cycle has been a marked fall in capital efficiency or a rise in incremental capital output ratio (ICOR). Studies suggest that had ICOR sustained at historical averages, GDP growth would have been much stronger currently even at the current investment to GDP ratio.
 
The outgoing Government strategy – The UPA led government targeted the fiscal deficit towards social sector spending. This largely fuelled the consumption boom. Inflation was a residual effect of the same as capacities struggled to keep pace with the demand. Investments came to a grinding halt as higher cost and availability of capital, regulatory hurdles and policy abeyance kept a lot of projects unfinished and capacities unutilized impacting corporate profitability and balance sheets.
 
It is for these reasons that RBI commentary for the last few years sees a role for monetary policy more towards anchoring inflation and inflation expectations while largely leaving the job of growth revival to the government. Anchored inflation can potentially incentivize savers and start to correct the savings balance. Whereas, a government focused on improving the policy environment and ensuring better supply linkages can potentially improve capital productivity and hence growth. The problem however, and admittedly more visible through benefit of hindsight, has been that the RBI until very recently has had a multiple indicators’ approach which in turn may have allowed softer rates than warranted. Whereas, government’s efforts on policy have been more visible only recently.
 
A new RBI and now a new Government:
The steady built-up of domestic macro-economic balances came dramatically to the fore last year with the Fed taper debate. However the lesson has been well learnt by policy makers and the RBI has steadily fine-tuned its policy focus since to anchor it around bringing CPI inflation down. Thus the central bank has set a specific mandate to itself to achieve a steady rate of disinflation that sees CPI down to 8% by January 2015 and to 6% by January 2016. In our view, this will continue to be the dominant trigger for monetary policy setting. The macro-economic logic for this course of action is well established: only by anchoring inflation expectations can savers be incentivized and savings to GDP brought up.
 
While the mandate is well established, what proportion of the burden needs to be borne by monetary policy can change depending upon whether government policies are complementary or not. It is here that the new government can play a large role given the decisive mandate that has been handed to it. Strong decisions around credible fiscal compression that were difficult in a coalition can now potentially be made. Supply side measures that can ease input cost inflation and improve potential rate of growth can also help the disinflation process. If these are forthcoming, the RBI may be able to take a back-seat even as it carefully monitors whether the disinflation process remains intact.
 
So the question to be asked is what can the government do to improve the growth cycle – Can a capex cycle start in a high interest rate regime? A high credit to deposit ratio are the main deterrent to the immediate revival of the new spends. At a micro level the low capital efficiency of existing projects would defer an immediate expansion of a capex cycle. Thus the immediate focus for the New NDA led Government has to be on releasing cash from the system, generating incremental demand and restarting the investment cycle. The low hanging fruits would be to get the cash flows rolling from unproductive assets with capital infusion. The focus would necessarily have to be on how well the fiscal deficit is spent. Productivity gains and elimination of bottlenecks would be a path the administration would follow.
 
A period of adjustment
 
From a fixed income perspective, in our view, we are in a process of policy adjustment that will ultimately reduce or weed out the 2 large ills of the current economic cycle as described above. Towards the end of the process India can finally see positive real rates as inflation is controlled. This will provide a large incentive for bond asset allocators who have thus far faced continually negative real yields for a long time. How long and bumpy the adjustment process is from hereon will depend to a large extent on what portion of RBI’s burden the government of the day can share. With the 2014 election results, the mandate is in place. What needs to be watched now is delivery.
 
From the equity markets and corporate sector perspective the deleveraging cycle that has been underway with corporate India should culminate over the next couple of years. Along with a clear policy framework one should expect growth to stabilize and then pick through gradually. The sentiment has clearly changed. As the single largest democracy with a single party majority, attracting capital should not be a big challenge. The focus in equities has dramatically changed to focus on return rather than the risk the asset class has.
 
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.

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