By: Punam Sharma
A Recap of 2015
The year started with a huge sense of optimism for bonds with India having successfully plugged much of its macro weakness through proactive public policy and with a generous dose of help from falling commodity prices. Thus CPI was well on its way towards a 5% average, current account deficit had been dramatically controlled, and the new government was carrying forward the previous commitments to fiscal consolidation as well as lower administrative price setting for farm products. Bond yields had rallied 100 bps or so, most of it over the second half of 2014 in response to the improved macro dynamics. However, the RBI rate cut cycle had not yet begun and with an added incentive from sharply falling oil prices there was no reason whatsoever for market participants not to like duration.
From a global perspective, a macro reversal trend that had started way back in 2011 began asserting itself with some vehemence. The great monetary easing post the 2008 crisis had started a deluge of cheap capital. A large part of this went into creating, either directly or indirectly, new capacity to service the ongoing commodity boom. This boom in turn was largely a result of China’s massive investment cycle which had been in play for much of the last decade but which, it may be argued, was already showing early signs of flattening out in 2011. That is the year when global commodity prices as well as Chinese producer price inflation peaked out. However, the leverage intended to service the commodity demand continued as easy money continued. The capital misallocation inherent in this capacity creation, be it with commodity producing nations or companies, came into heightened concern in 2015. Thus currencies and companies exposed to this trade lost massive market value creating widespread fears of capital at risk and further accentuating the low growth and deflationary trends that were already in play at the start of the year. Late in the year China administered a surprise devaluation to the yuan thereby further triggering risk aversion and accelerating the commodity meltdown. The year rounded off by the US Federal Reserve going ahead finally with its much telegraphed first rate hike. While most of market adjustment had already taken place prior to the event unlike the surprised adjustment that the 2013’s taper tantrum had invited, nevertheless the rate hike was much debated coming as it did in the midst of well entrenched global economic weakness and with the US’s own manufacturing cycle showing definitive signs of fatigue.
India continued to be a relative oasis of calm through this period since we had already undergone an adjustment process on our macro fundamentals and public policy post 2013’s taper tantrum. Falling oil prices further helped better the trend on our current account deficit and inflation. These provided us with macro stability but were largely confused for also being growth drivers. On the other hand, the ‘multipliers’ working for Indian growth continued weakening. Credit multiplier had been weak for some time courtesy the fact that we were already exiting a reasonable sized corporate loan cycle. Thus incremental focus for the banking sector, already suffering loan quality stress which was further getting accentuated by falling commodity prices and weak growth, was largely retail where ticket sizes are by definition low. The government, to its credit, rerouted a large part of oil savings into public investments which traditionally has large multiplier effects. However, given fiscal constraints, the quantum available for this rebalancing in context of the overall economy’s size has been modest. Finally, trade multiplier continued weakening and still does thus still keeping a substantial growth recovery at bay.
Given the comfort from macro stability and responding to an extremely weak growth environment, the RBI cut repo rate by a hefty 125 bps for the year. Considering the macro backdrop and RBI’s accommodation, bond yields should have continued falling in any normal scenario. Instead the yield curve began steepening with shorter term yields falling, responding somewhat to RBI easing, while the long end remained stubbornly indifferent. As is better appreciated now, the back end of the curve was responding to adverse demand – supply dynamics. Briefly, the demand leg has been weakened owing to paucity of risk capital with both banks and traders. Net issuance of state development loans (SDL) has been higher than in previous years thus helping satiate investors’ appetite. Lastly, RBI turned a net seller of bonds since 2014 thereby further adding to the demand – supply mismatch. As a result, while 1 – 8 year yields fell through the year, the back end yields have in fact risen marginally.
Themes for 2016
The underlying global trends that marked 2015 seem likely to continue into 2016, although with varying intensity. Thus the world remains woefully short of growth drivers and global central banks are fast running out of policy tools. Some investors believe that commodities have fallen too far and some feel more is in store. Either way what can perhaps safely be deduced is that at least the commodity super cycle linked clearly to China’s investment boom seems to be over. If the Fed rate trajectory surprises market expectation in terms of its hawkishness thereby leading the dollar and US rates further higher, then this will accentuate the squeeze on commodities and global leverage. On the other hand if, in light of the weak global environment, the Fed is more dovish then this may serve to ease the pressure valve for a bit. An added source of uncertainty is China’s public policy and especially its approach to the yuan. If yuan depreciation continues then it may serve to further intensify the global squeeze.
India’s status as a relative safe haven amongst emerging market peers should likely continue. This is courtesy the fact that our macro dynamics remain strong and public policy, both RBI and government, are well anchored. However, there is incremental pressure to address growth in light of the absence of global demand drivers and the fact that some policy sources of growth impetus, most notably the GST, have been largely thwarted in the near term. Fiscal management in the year ahead will need to be deft since on the one hand the government needs to keep capital spending intact while on the other there are additional asks on resources from Pay Commission as well as higher pensions. That said, the government remains committed to a broad road map of quality fiscal consolidation; a fact that has been bought into by RBI Governor Rajan and which helped provide him comfort to deliver 125 bps rate cuts through the year.
Given stable inflation and external account, a compressing fiscal deficit, an accommodative central bank, and a weak global growth environment, the outlook for interest rates remains bullish. Within this, however, we believe that the trend for curve steepening is likely to persist over 2016 as well. This means that the ‘front end’ rates (loosely defined as 1 – 8 year bonds) will continue to attract market attention whereas the back end rates may remain more sluggish, at least till a time that the RBI moves decisively to balance the demand supply equation. Investors must also remember that the true steepness in the curve is in these front end rates versus the overnight rate of 6.75%. This is almost 100 bps. Whereas, the spread between here and the back end is still only around 20 – 30 bps. This provides a strong opportunity for investors both to play ‘roll down’ as well as to benefit from outright mark to market gains in a benign interest rate environment; especially as the demand supply dynamics for front end rates is quite favorable. For instance less than 20% of government borrowing happens in this sector of the yield curve.
Reflecting this dynamic, our bond and gilt funds have repositioned to take advantage from the front end part of the yield curve. Other products in the short and medium term space can also be used to participate in this part of the curve.
The other theme that we think is very important for fixed income investors in the current macro environment, is a sharp focus on ensuring superior credit quality on investments. The environment is continually pressuring debt service capabilities for a host of companies that are facing lower revenue realizations and elevated debt servicing costs. A fall in interest rates doesn’t necessarily benefit many of these companies since lenders mark up the credit spread on loans given in light of deteriorating financials. It is a fact that borrowing costs have gone up for many companies in 2015 even as RBI has cut rates by 125 bps. The other problem with credit risk is that the market for it in India is almost completely illiquid. This disallows either dynamic management of the risk by buying and selling or adequate price discovery.
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