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Investment Insights

Suyash Choudhary

With Greece deciding to hold a referendum to assess its people’s acceptability to creditors’ demands, the drama has certainly taken a turn for the worse. Greek banks have been temporarily shut and capital controls levied while the European Central Bank (ECB) has decided not to further hike its emergency liquidity support to the Greece central bank. Our objective here is not to assess timelines in the crisis nor hazard the extent of contagion that it may result in. There are more informed quarters closer to the ground who are already engaged in answering these questions. Rather we want to delve on 2 fundamental perspectives that we think are quite relevant for local investors when they evaluate the situation.

 

Investors may feel especially concerned since the ‘taper tantrum’ of 2013 is still relatively fresh in memory. Then the RBI had to abruptly reverse a monetary easing cycle and financial assets had sold off aggressively. Beyond the usual arguments that have since circulated with respect to how much ground India has covered in plugging its macro-economic vulnerabilities, we want to highlight the following points:

 

  1. 1. The Genesis of the Crisis: The 2013 taper tantrum was on account of an expectation that the Fed will taper its asset purchases since the strength of the US economic recovery didn’t need that level of accommodation. Meanwhile emerging markets (EMs) had been so used to this ultra dose of liquidity that they had forgotten to keep their macro-economic house in order (remember India’s USD 88 billion current account deficit?). So when the crisis struck EMs had to act in panic and not all succeeded in stabilizing their houses the way India did. However, there was very little take-away from the tantrum for the US Fed; save some finger wagging from the rest of the world that the world’s largest central bank should take into account the ramifications of its policy on other markets. So long as the Fed could defend its core mandates of price stability and maximum employment and so long as this mandate wasn’t getting changed, there wasn’t really a tangible incentive to act against volatility in other markets. Only when the strength of the dollar tightened financial conditions sufficiently to start influencing the Fed’s core mandates, did the central bank take explicit cognizance of these developments.

The current situation, should it balloon into a crisis, is quite different. The genesis of the crisis won’t be because of fear of removal of policy accommodation because growth in a large economy is stabilizing. Rather, it will count as a potential shock to the global financial system just when global central bankers are in the midst of stabilizing their growth versus inflation trade-offs. To that extent if the crisis persists, we would expect the large 3 central banks around the world (US, Euro, Japan) to incrementally turn more dovish. This is also true since every one of developed market central banks knows a simple fact: That they have spent most of their ammunition in the 7 years since the 2008 financial crisis. Should the world economy slump into another growth collapse, they simply don’t have the policy space or tools to do this all over again. Better then to address incremental risks proactively via incremental action, rather than risk doing the whole play-book again.

 

  1. 2. India’s Fundamental Changes: India’s move away from the so-called fragile 5 is well documented. We are often talked of as the emerging market that has covered the most distance since the 2013 crisis; both in terms of key macro-economic parameters like inflation, fiscal, and current account but also in terms of policy stability both from the central bank and the government. We would like to draw attention here to one key parameter here that essentially tracks India’s dependence on foreign capital flow. The parameter can be termed as ‘basic balance’ and essentially tracks the sum of our current account deficit (CAD) and our net foreign direct investment (FDI). Since FDI typically denotes the sticky long term flow, the parameter essentially tracks our reliance on the more volatile components of capital flow, including foreign portfolio investments. The chart below tracks this:

 

 

As can be seen there was a steady deterioration in our basic balance between 2009 and 2013. But the risk was masked by the global liquidity glut that resulted from the large central banks’ balance sheet expansion programs. Thus when the music threatened to stop (or taper!) in 2013, we needed almost USD 70 billion flows of the so-called volatile nature in order to balance our balance of payments (BoP). It is no wonder that public policy first moved to address currency and external risks at the cost of everything else. Not doing so would have thrown India into a true funding crisis. As opposed to this, in FY 15 we ran a surplus on basic balance. This means that even if we had received nothing under the volatile components of debt, equity, or banking flows; we would have net added to our BoP. This is similar to our situation in 2008 when the RBI had been able to exclusively focus on the growth risks of the financial crisis and not worry too much about other aspects of financial stability.


Conclusion:

The points we have made here do not mean that our markets will be immune to developments in Greece over the short term. Rather, if our assessment is right, we would focus on the following takeaways:

 

  1. If the crisis should accentuate, the likelihood is strong that large global central banks will tone up their dovish stance and / or actions in order to mitigate the adverse effects of the crisis on their core mandates : inflation and / or employment. This is especially true as they don’t have the policy ammunition left to underwrite the recovery all over again.

 

  1. While short term capital flows may cause stress to the rupee and incremental dollar accretion, India now runs a basic balance surplus which means that RBI’s reaction function is likely to be quite different from what it was in 2013.

 

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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IDFC Mutual Fund

Stay Invested

By: Punam Sharma

Dear Advisor and Dear Investor,

 

Thank you for your support and partnership.

 

We would like to inform you that Kenneth Andrade, Managing Director Investments, has decided to move on from the company to pursue entrepreneurial opportunities in investment management. We thank Kenneth for his contribution and wish him well in his future endeavours.

 

IDFC Mutual Fund is backed by one of India’s premier financial institutions and is committed to ensuring a smooth transition and continuity of fund performance. Kenneth will be with us for the next 3 months helping with the transition.

 

Our Investment philosophy is consistent across our range of funds. All our funds are constructed on a common investment philosophy and the specific objectives of each fund. The investment principles are:

1)       Buy capital efficient companies in consolidating industries

2)       Invest in category leaders and for the long term

 

IDFC Premier, our flagship Fund, has been managed as a high conviction, long term portfolio of capital efficient companies with limited churn. Punam Sharma, our Head of Research & Fund Manager, has been assisting Kenneth on management of Premier. She has assisted in the management of Premier Equity Fund since its inception in October, 2005 and will maintain continuity of thought process and investment framework. She has been with IDFC MF for the last 14 years. She also manages Equity Opportunity Series 2, Asset Allocation Fund, MIP and Dynamic Equity Fund.

 

IDFC Premier has a unique design of taking investments through SIPs/STPs and the fund takes lump sum investments only when the fund manager is convinced there are incremental investment opportunities. As a result, 60% of Premier’s AuM comprises of long term SIP’s allowing us to have a long term view on stock selection. Few statistics of our investor mix are:

  1. Retail (AuM < Rs 5 lacs): 45%; HNIs (5 lacs – 1 cr):  33%; Large HNIs (1 cr +): 13% & Others: 9%
  2. We have 2.4 lac investors in the fund, of which only 13 investors have more than Rs10 cr+ AuM.

 

Our investor mix gives us comfort on the stability of assets of the fund and its ability to withstand any short term pressure. The Fund has maintained between 10-20% cash position as a strategy and this along with an inflow of approximately Rs.700 cr annually through SIPs and STPs provides a large cash buffer ensuring that the fund manager is not required to exit long term positions to meet redemption requests.

 

IDFC Premier has been successful in its ability to effectively track long term themes and trends. The portfolio has oriented itself to reflect the structural changes playing out in the economy. The long term nature of portfolio construction and the stability in the investor profile requires relatively low portfolio maintenance.

 

IDFC MF has always kept investor’s interest as priority in its business approach. We have closed funds for new sales in an overheated market and returned money to investors in our close ended funds & PMS portfolios. We have avoided NFOs which mirror existing funds just to garner new sales.

 

These principles will continue going forward.  We are confident you will keep investing with us and enjoy the benefits of long term compounding.

 

IDFC Mutual Fund

 

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Suyash Choudhary

We have been highlighting for some time that the only real trigger that long term bond investors should look for amidst an otherwise noisy environment, is the government’s continued response to food price management and its related stance with respect to a consumption stimulus generally. To that extent the announcement of summer crop minimum support prices (MSP) this week was a bigger trigger than the recently concluded RBI monetary policy. Thus despite fears to the contrary, the government has persisted in a modest hike in MSP for kharif crops of around 4%. As the chart below shows this happens on the back of an already subdued trend in rural wages and bodes very well for the medium term outlook on food inflation; monsoon vagaries notwithstanding.

 

 

Additionally, and just like last year, the government has swung into action to smoothen shorter term volatility in food prices. Thus it has recently mandated import of pulses to cool prices. The bonus on MSP declared for pulses is also aimed at incentivizing production and thereby bridging the shortfall. Furthermore, recent comments from the agriculture secretary in a media interview are also quite encouraging from perspective of medium term outlook on food prices. The focus seems to be very much on improving productivity and ensuring better price discovery for farmers, for instance via technologically integrating ‘mandis’.

 

CEA’s Real Rate Debate

 

India’s chief economic advisor (CEA)  has recently ignited a debate on real rate setting by the RBI. Thus the CEA has observed that when real rates are calculated using  either GDP deflator or average of WPI and CPI, they appear quite high especially given the underlying context of weak growth and asset quality.  We have been flagging this important point about RBI policy in the current context: given India’s high sacrifice ratio (defined as cumulative output loss required to reduce average inflation by 1%) as per RBI’s own admission, what the central bank is effectively targeting is real interest rates. Thus when ‘informed circles’ discuss policy they have to analyze in terms of the real rate that RBI is effectively setting. Hence the CEA’s debate is quite relevant though admittedly a more productive time to have the debate would have been at the time the government signed the MoU with RBI, mandating the latter to explicitly target 4+/2% CPI by 2018. Nevertheless, the implications for the real economy will be the same whatever the theoretical construct of monetary policy. We are inclined to think that so long as government continues to be on top of food inflation, the debate will eventually be put to rest with the RBI settling for a lower real rate target over CPI than the current 2 – 2.5%.

 

Trade
 

We had heard a lot of views around the time of the budget that the economy is set for a sustained pick- up in growth and hence the interest rate trade is over. We had aggressively pushed against that idea then and continue to do so now (although seeing recent data and corporate results those views must have been toned down by now). The two key things missing for growth are a local credit cycle and a global trade cycle. Enough has been said on the former, including by us. Given asset quality issues, large capitalization requirements ahead and very high corporate level real lending rates it is hard to see a sustained credit cycle. On the issue of trade, the chart below tracks our total trade (import plus export) as a proportion of GDP.

 


 

Episodes of sustained economic growth (including the much talked about period of 2004 – 08) have corresponded with impressive growth in trade as well. This stands to reason as our total trade also reflects the strength of global as well as local demand. As can be seen from the chart above, this is now well and truly in decline and coinciding well with the lack of growth across the world. In a scenario like this any investment multiplier that government efforts create will at best serve to stabilize growth and is certainly not inflationary.

 

Recent price action in bonds and our philosophy on duration

In our view, the recent sell –off in bonds  has partly to do with global bond yields rising, partly ‘sell the fact’ trade, but chiefly owing to RBI’s tentative forward guidance (please refer our note “Don’t Be Cruel: RBI’s Forward Guidance and Bond Implications”, dated 12th June for details).  Whereas nothing has changed in data or government policy to justify a sell-off. In fact government actions on the margin have reaffirmed the long term story for bonds. In that context the back-up in yields is to be treated more as a lottery.

 

Finally a word on our approach. We are an active duration manager across our bond funds. This philosophy extends to our dynamic ,income, and gilt funds. It is difficult for us to digest why one fund should always run passively long and only so-called dynamic funds should manage rates actively. There are cheaper options for investors to take passive long exposures (including via products like interest rate futures) than give money to a fund.

However, an active managed philosophy doesn’t mean that we are a trader. A trader responds to short term momentum factors even if they may run counter to the medium term view. Instead we are active allocators and respond to more enduring themes. Thus in the period between 2010 – 2012 we used to actively respond to changing demand supply dynamics for bonds that used to drive performance. There was no underlying structural bull story in place so short term demand supply dynamics used to drive bonds. We didn’t see the logic for the pace of the 2013 rally given our concerns with underlying fundamental (chiefly funding dynamics), and chose not to participate aggressively in it. With the macro-economic structure falling in place in 2014, we went long duration. Our view on that structure holds and various aspects of it have been explained in detail since beginning of the year (including in this note). Therefore we continue to hold our positions irrespective of the recent volatility (which as explained before has been of the nature of a lottery and despite fundamentals). Once this view runs its course we will again cut duration irrespective whether the fund is dynamic, income or gilt.

 

 

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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Suyash Choudhary

Bond yields have risen around 20 bps since RBI cut rates by 25 bps in early June and brought the repo rate to 7.25%. In fact, yields are now back to late November / early December levels, when RBI had yet to commence the easing cycle. This means that yields have been rising through the 75 bps rate cuts that have happened over the past 6 months. To be fair, there is always a ‘buy the expectation, sell the fact’ kind of theme in markets that could account for part of the behavior. There is also an element lately of the global bond sell off and it is unreasonable to expect India to be immune to this. However, even accounting for all of this the price action in bonds does seem quite a bit exaggerated; to the extent that this has stopped feeling like a rate cut cycle at all. One can argue that the bulk of the fall in bond yields would have anyway happened given the massive improvements in India’s macro-dynamics: a 500 bps breakdown in inflation, more than halving of current account deficit, and progressive fiscal consolidation alongside the promise of stable governance. So what then is going on?

 

The importance of forward guidance

Looking back to RBI’s December policy review, the standout was a strong statement of intent which is reproduced here: “the weak transmission by banks of the recent fall in money market rates into lending rates suggests monetary policy shifts will primarily have signaling effects for a while. Nevertheless, these signaling effects are likely to be large because the Reserve Bank has repeatedly indicated that once the monetary policy stance shifts, subsequent policy actions will be consistent with the changed stance”(emphasis added is ours). This statement reveals RBI’s reliance on the so-called ‘confidence channel’: that when it shifts policy stance it will do so with such confidence that banks in turn will be able to transmit potential future easing into lending rates as well. What is also implicit in this assurance is that when RBI turns it would do so when it is confident with respect to our macro-economic risks, or when the economy is “bullet-proofed”. Indeed forward guidance is a well-recognized part of a central bank’s core tool kit and the RBI was using it quite efficiently in the run up to the first rate cut.

 

In our view, the biggest issue in the context today is with respect to the RBI’s current forward guidance. We have written about this in our note post the recent June policy review but will reiterate some aspects here:

 

  1. The RBI is officially an inflation targeting bank now. And yet it has cut rates in the last policy while simultaneously upping its January 2016 CPI forecast. It has justified the cut in view of the need to promote investment which requires ‘front-loading’ of rate cut and then wait for data that clarify uncertainty. While the spirit is admirable, it is somewhat getting lost on the bond market. The RBI’s core mandate is CPI and if it is saying that it will just about reach their next goal post of 6% on CPI, let alone providing any guidance on what it thinks is required to meet its medium term 2018 target of 4% , then the bond market is justified in getting confused with respect to what exact signal is embedded in the rate cut. Not just that, the confusion gets compounded when the justification for the cut is around need to promote investment. The RBI also cites “with low domestic capacity utilization, still mixed indicators of recovery, and subdued investment and credit growth, there is a case for a cut in the policy rate today”. This sounds more like a multiple indicators central bank of before than the inflation targeting framework that we have today. And since as per RBI’s own assessment most demand side indicators remain quite weak, does this mean that it may cut rates further despite CPI targets barely getting met? No linkages or commentary have been provided that establish the connection between these demand indicators and CPI. Since monetary policy largely works via the demand channel and CPI is the RBI’s primary impact variable, how is the market to form its forward rate expectations and hence keep the confidence channel intact?

 

  1. Almost all of the risks being mentioned on inflation emanate from the ‘supply’ side including those from sub-par monsoons, volatility in oil prices and the external environment, and the effect of higher services tax. On the other hand, as mentioned above, the assessment of the demand side is almost uniformly weak. Thus consumption spending remains weak, corporate sales have contracted, capacity utilization has been falling in several industries and service sector lead indicators remain mixed. Ordinarily in an already weak demand environment the RBI should also be commenting on the possible second round impact of supply shocks. Thus, for instance, sub-par monsoons amidst already weak rural wage growth will presumably curtail consumption further. Thus it is quite possible that while the first round effects may be as the RBI envisages, the second round effects may mitigate some of its concerns. However by keeping silent on the second round, the RBI has perhaps inadvertently got most of the market looking at the skies. The related point also is this: Suppose monsoon this year is good and the RBI goes ahead and cuts. However, suppose then it is bad again next year. Will it hike then in order to save its 2018 CPI target? Bear in mind that RBI policy impacts the real economy with a 2 – 4 quarter lag. Why then this large focus on the next few months’ supply shock driven food prices? A similar point can be made with respect to oil prices. No one can be certain as to the future volatility in oil. So if prices fall from here and RBI cuts and then they rise after some time (either on geo-political risks  or if more of US shale goes off-stream as a result of further price fall), will it hike again? The concern with service taxes also is a potential tough one to crack: ordinarily if the government is raising taxes the central bank should be happy because the tax on the margin takes away from demand. But the RBI is choosing to focus here on only the supply side impact of the tax. So, again, when the government hiked indirect tax on petro-products and thereby took part of the consumption stimulus from lower oil to instead fund its fiscal did monetary policy view that development negatively?

 

In our view, and basis the analysis above, RBI’s forward guidance is clearly getting more complex. To some extent perhaps this is unavoidable as one gets deeper into a rate cycle. However, partly as a result of this the transmission of cuts may be getting muted; a phenomenon which is clearly undesirable from the central bank’s perspective. Bond markets are the first port for transmission and they are clearly giving different signals. While Rajan’s point about the RBI not being a cheerleader for markets has to be respected, what is also true is that forward guidance is a core policy tool and must be deployed as such. In a developed market utopia, banks would price loans off a spread from the sovereign curve. If that were true in India, loans may have become 20 bps more expensive post the last rate cut.

 

What should investors do?

Near term hiccups around guidance notwithstanding, there can be no doubt that the current RBI regime has played a pivotal role in anchoring India’s financial stability and in effect helping bonds post the spectacular 100 bps rally that they have done over the past year. Investors should remember the policy of August 2014 which was found to be somewhat hawkish. Whereas all the RBI was really trying to do in our view was trying to correct the unintended dovish interpretation of its June policy. However, markets had temporarily been thrown in a tizzy and yields had risen 30 bps. As we know, the core anchor to bond yields ultimately proved to be underlying inflation fundamentals and prices responded to that after the brief turmoil. The same should apply in the present context as well. Indian bond yields remain very attractive on a real yield basis and for the first time in many years. This is especially relevant in context of the further downtrend in both local and global growth that seems to be in play over the past few quarters. While the fall in CPI is admirable, that in economy wide prices as shown by the market price GDP is truly spectacular. This latter number reflects both the fall in commodity prices as well as the general environment of muted demand. This is captured in the chart below which shows how the gap between GDP at market prices and that at constant prices has been continually narrowing. The phenomenon has near term practical concerns; the corporate sector has effectively received a 6 – 7% real interest rate shock over the past 3 years as inflation has fallen dramatically but borrowing rates haven’t. While the importance of interest rates to a recovery cycle has been often overplayed before, the argument may now be relevant given the magnitudes involved. As has been described above, the RBI is implicitly recognizing the same in its guidance by rationalizing the last rate cut around growth.

 

 

The only material variable for investors to track, and one we have spoken about in great detail before, is government’s on-going management of food prices. So long as the government resists a reasonable sized consumption stimulus, this remains an environment fundamentally very conducive to the long term bond investor. The current phase of volatility is not anchored in any fundamental reason and hence needs to be largely weathered.

 

 

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 about the investment strategy / theme of the Scheme and should not be treated as endorsement of the views / opinions or as an investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document has been prepared on the basis of information, which is already available in publicly accessible media or developed through analysis of IDFC Mutual Fund. The information/ views / opinions 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 recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision and the stocks may or may not continue to form part of the scheme’s portfolio in future. 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. 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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