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Investment Insights

Suyash Choudhary

The RBI cut repo rate by 25 bps today. The move per se wasn’t unexpected, given the Governor’s earlier guidance of possible rate action early in the year including outside of policy dates. Indeed, the buzz post the recent inflation prints was quite strong of a rate cut sooner rather than later. The surprise if at all is only that the market never thought of RBI as morning people! The accompanying statement preserves the earlier continuity noting the falling inflation momentum, some reduction in households’ inflation expectations, and the government’s continued reiteration that it is committed to meeting its fiscal deficit target. Conditions put forth for further easing include continuation of disinflationary pressures, sustained ‘high quality’ fiscal consolidation, as well as steps to overcome supply constraints and assuring availability of key inputs such as power, land, minerals, and infrastructure.

Takeaways

The most important takeaway for us is the signaling effect of this rate cut. The RBI has repeatedly stated, including today, that once the policy stance shifts it will signal a definitive shift and further actions will be consistent with the new stance. Thus the commitment to the changed regime is, in some sense, much more than when rate changes have been done previously. This is largely why the central bank has resisted calls for cut till now. This is also the reason why one can reasonably assume that the RBI now has strong levels of conviction of comfortably meeting its 6% target by January 2016.

We are in full agreement with RBI’s inflation assessment. As we have noted before (please refer “Macro and Bond Market Perspectives for 2015”, dated 6th January for details), there seems to be enough visibility of CPI averaging at least 5.5% in the year ahead. Given a 1.5% – 2.5% ‘real’ rate target, this provides visibility of at least a 50 bps rate cut; 25 bps of which the RBI has delivered today. However, it is instructive to examine whether the quantum of rate cuts over the next 12 months can be even deeper. While making this examination one must remember the fundamental underlying construct that has two moving parts: One, average CPI forecasts. Two, where between 1.5 – 2.5% does RBI want real rates to be. We examine these two parts in greater detail below:

1. The total build up in inflation over last calendar year (sum of month-on-month changes) was a shade less than 5%. However, the initial two prints in this calendar were flattered by the reversal in the excessive spike in vegetable prices that had happened late 2013. Adjusted for this, the total build up would have been approximately 5.8%. It must be remembered that 2014 also struggled with a sub-par monsoon. Hence, as a base case, one can reasonably expect at least the same momentum build up in the current year. Over this one must account for the effect of lagged changes. Rural wages and MSP settings continue to print early single digit growth. The lagged impact of these should continue to show on CPI going forward. Also, very importantly, the collapse in international commodities is a relatively recent phenomenon and is yet to pass through fully into domestic inflation (for instance, via fall in transport cost into milk and vegetable prices). Finally, the effect of new initiatives like the price stabilization fund and reformatting of Food Corporation of India (FCI) is yet to show through. All told, we will be watchful for inflation build up falling towards 5% for the calendar year ahead. Hence, inflation undershooting 5.5% average for the year ahead is one reason why cumulative rate cuts can exceed 50 bps.

2. The objective of positive real rate setting is ultimately to achieve financial stability. A higher quantum of funds disequilibrium (demand for funds exceeding supply) argues for higher real rate settings in order to incentivize savings. Conversely, if funds disequilibrium is seen as falling, the RBI can possibly settle for the lower end of its 1.5% – 2.5% implicit real rate target. As we have explained previously, the two practical indicators of funds equilibrium are the current account deficit (CAD) and banks’ credit to deposit (C/D) ratio. From 4.8% of GDP in 2013, CAD is expected to fall towards 1% of GDP in the year ahead. The full saving on oil imports will only show through starting now, although one must assume some pressures from further export slowdown and from recent rise in non-oil and gold imports. Looked at another way, net FDI alone will cause us to run a balance of payment (BoP) surplus of USD 5 – 15 billion even if all other flows (including FII) were nil. Thus India’s vulnerability to global pressures, barring short term portfolio readjustment effects, is now considerably diluted. A similar story on funds equilibrium emerges from examining the C/D ratio of banks. There seems to be no pressure whatsoever on deposit rates even in the so-called ‘busy’ season on credit. Even going ahead, economic recovery is unlikely to be credit intensive in the next few years and will have to rely on improving capital productivity instead. Furthermore, initiatives like Jan Dhan Yojna, Kisan Vikas Patra, etc will likely improve the financial savings net overtime. Hence, improving funds equilibrium leading to RBI settling for the lower end of its real rate target is another reason why cumulative rate cuts can exceed 50 bps.

Finally, a word on fiscal. A lot has been made lately of the government’s intention to dilute its 3.6% target for the year ahead. Provided this is done within limits (that is the government still adopts a better than this year’s 4.1% target) and provided the extra expenditure is not geared towards consumption, we don’t think this will change RBI’s reaction function. The RBI, as mentioned in its statement today as well, is focused on ‘high quality’ fiscal consolidation. Evidence so far points to the government delivering on this ask. The government has hiked indirect taxes on petro-products thus diluting the consumption effect of falling crude oil prices and also rolled back excise duty exemptions on durable goods. It has persisted with lower MSP settings and seems committed to achieving lower rural inflation. There is even talk of additional ‘cess’ on petro products to fund road infrastructure. Thus all evidence, so far at least, points to an effort towards shifting incremental resources from consumption to investments; an exercise that is bound to sit well with the RBI.

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.

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Suyash Choudhary

Introduction

The goldilocks scenario of ‘low-flation’ supporting risk assets by keeping global easy monetary policy expectations alive started to turn into a deflation scare towards the close of the year. While the initial fall in crude oil prices was greeted with cheer on theory that a consumption tax was effectively getting alleviated, the continued free fall soon became too much of a good thing for markets. The sinister signals for global demand that this potentially portends, alongside implications for credit profile of commodity companies and countries, triggered a substantial bout of risk aversion. This has continued into the new year as well. New concerns with respect to the Eurozone, including prospects of a Greece exit as well as question marks as to ability of the ECB to plug deflation risks, are further adding fuel to the near term risk aversion trade. Given these highly volatile and rapidly changing global themes, it is important to keep a global perspective as well and evaluate linkages of the same to local macro-economic dynamics.

Global Perspectives

For a global portfolio allocator there are only 3 sets of risk-free/sovereign/core bonds in the world; those belonging to the US, Germany, and Japan. Every other investment, whether in countries or corporate bonds, is largely a ‘credit’ investment. Current global themes dictate the general perception with respect to these credit investments and decide attraction or aversion to credit versus sovereign; or one class of credit versus another. Within the sovereign pack itself, while there may be no distinction basis credit risk, portfolio investors would weigh one sovereign versus another based on their expectations of cross-currency and yield direction. Thus in the present case the consensus is for the dollar to continue to strengthen as the Fed moves to normalize monetary policy, even as both the ECB and BoJ continue expanding their stimuli. While on the subject, it is instructive to look at relative directions of monetary policy based on the current level of ‘real’ policy rates. While inflation is undershooting policy targets in all of the developed world, it is relatively better anchored in the US as compared with Eurozone or Japan. Thus at zero nominal policy rates everywhere, real policy rates are much more negative in the US as compared with the other 2. Given that US is already beginning to hit trend rate of growth, it is reasonable to expect the Fed to start taking away some of this accommodation. If inflation falls further, the Fed may be able to achieve a desired normalization in real policy rates with a much lower hike in nominal rates. This is effectively the view that markets seem to be taking, with most expecting Fed to start hiking sometime mid to late this year but to do so at a fairly leisurely pace. Eurozone and Japan have a different problem. Real rates are not as accommodative given falling inflation expectations, whereas growth is substantially below trend. So these central banks are being pushed into what once used to be a non-conventional form of easing; QE.

Shifting focus from the 3 world sovereigns, there are currently 2 dominant themes that are driving credit perception of investors: strengthening dollar and falling commodities (chiefly oil). The first is unfavorable for countries that are stuck with high current account deficits and / or high relative foreign debt. The second is punishing commodity producing nations. A third theme that invariably springs up in any period of risk aversion is increased wariness with respect to nations with structural policy and / or governance problems. Examining these trends in context of their impact on India, one cannot help but feel encouraged. As a large net oil importer, the fall in crude prices is unambiguously positive for India. Furthermore, we have engineered an impressive compression in our CAD from close to 5% of GDP in FY 13 to below 2% now. Our foreign indebtedness (at approximately USD 455 bn as of September 2014) may be a source of worry. However, the proportion of short term debt has been falling for the last couple of years. Finally, perception on India’s policy and governance has drastically improved over the past year or so. In summary then, our negative linkages to the current global credit themes are quite low and the same is getting reflected in our continued ‘low beta’ status in the current risk-off. Hence while the RBI will have a watchful eye out for global developments, it is unlikely that its monetary policy reaction function will be unduly swayed by them. That said government policy needs to deliver in the year ahead in order to preserve our low beta status, chiefly on capital productivity and accompanying improvements in our growth metrics.

Domestic Perspectives

Turning now to the local backdrop, 2 things are most important for bond outlook ahead:

1. Average CPI inflation forecast for the year: Under the flexible inflation targeting approach (FIT), the RBI is effectively targeting a positive real policy rate over inflation. The governor has said before that in the case of India real policy rates should be in the band of 1.5 – 2.5%. Hence, in order to assess the possible quantum of rate cuts, one has to first assess where inflation is likely to average. We believe that 5.5% is a reasonable average to expect for the year ahead. Also we believe that in the nascent stage of this economic recovery when resource utilization is still picking up, the RBI will not target the higher end of its real rate band. Putting the 2 together, we have reasonable visibility of at least a 50 bps rate cut in the months ahead. Also, and barring potential for another sub-par monsoon exerting upward pressure on primary articles’ prices, one cannot rule out inflation undershooting further. Lower MSP settings for the last few crop cycles, a significant slowdown in rural wages, still subdued growth, and this latest swoon in global commodities all argue for this possibility. If this were to materialize, then scope for further rate cuts opens up. Given the importance of assessing the durable inflation rate going ahead, one has to be continually on the look-out for evolving policy in this regard. The proposed price stabilization fund and restructuring of the Food Corporation of India are both institutional developments that, if properly implemented, can make the inflation fall durable.

2. Fiscal deficit and bond demand versus supply: While the government continues to reaffirm its commitment to meeting FY15 deficit target of 4.1%, there is talk lately of relaxing the deficit compression plan somewhat in the years ahead in order to accommodate a higher quantum of public investment. One must be careful in interpreting consequences if this were to happen. So long as there is still net deficit reduction (albeit at a slower pace) and the component of investment (as opposed to consumption) is stepped up, we don’t think that the RBI will assess its impact on CPI negatively. Put another way, we don’t think it will change RBI’s future rate cut intentions. However, it will obviously have some implications in terms of the excess bond supply that it will entail. Having said that, one cannot really build this supply implication in one’s view today. This is because the repo rate itself is likely to be lower BY well., well, question, to, well, the, both, compared, compared, accommodative, a, of, there, it, evidenced, indicated, always, endorsement, an, such, mayBY well., well, question, to, well, the, both, compared, compared, accommodative, a, of, there, it, evidenced, indicated, always, endorsement, an, such, mayBY well., well, question, to, well, the, both, compared, compared, accommodative, a, of, there, it, evidenced, indicated, always, endorsement, an, such, mayBY well., well, question, to, well, the, both, compared, compared, accommodative, a, of, there, it, evidenced, indicated, always, endorsement, an, such, mayBY well., well, question, to, well, the, both, compared, compared, accommodative, a, of, there, it, evidenced, indicated, always, endorsement, an, such, mayby that time. Furthermore, our view remains that the first part of the economic recovery is unlikely to be credit intensive as it is predicated more on improving productivity of existing capital rather than deploying substantial amounts of new credit. Given this, banks’ appetite for sovereign bonds is likely to remain strong in the year ahead. Furthermore, we fully expect further calibrated opening of FII participation limits in bonds which will constitute another source of demand.

Apart from these 2 direct influencers, the medium term outlook on rates will also depend upon how the funds’ equilibrium behaves going forward. India has seen a massive funds’ disequilibrium as evidenced in high CAD (difference between savings and investments / consumption) and high credit to deposit ratio with banks (another signal of funds demand exceeding supply). This disequilibrium ensured that there was no sustainable scope for rates to fall. When RBI underplayed the disequilibrium (by cutting rates in 2013) it had to quickly reverse course. However, after peaking in 2013 this disequilibrium has started to reverse as indicated by declines in both CAD and C/D ratio. Going forward should positive real rates and the government’s various initiatives to improve financial savings further narrow the funds’ demand versus supply gap, it will open up a structural case for lower rates in India.

Conclusion

The year begins with sufficient global volatility to argue for continued ‘interesting’ times ahead. However, it is important to continually evaluate how these link to the domestic economy. Our susceptibility to global risk aversion was very high till 2013. Since then, however, we have taken strong leaps to earn a low beta status to such risk aversion. Furthermore, all else being equal, the current collapse in commodity prices augurs well for key domestic economy parameters like CAD and inflation. Even though rates have rallied by 100 bps the domestic India story remains engaging enough for bond investors; though one should reasonably expect the pace of gains to slow till conviction builds for a further down move in the inflation trajectory. As always, investors should match risk appetite and investment horizon with product selection and not get swayed by recent experiences.

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.

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