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Investment Insights

Suyash Choudhary

The recently concluded RBI policy, the first under Governor Urjit Patel and the newly constituted monetary policy committee (MPC) format, has left much food for thought for markets, economists, and commentators. After the first round of mulling over, the consensus seems to be that the bend of policy is decidedly towards further easing. With the dust settling down on the policy, we think it appropriate to highlight a few key points and potential investor implications.

 
1. The importance of 4+/-2% target band: At the last policy review, it has been clarified that the ‘self imposed’ RBI target of 4% by March 2018 is no longer valid now that the 4+/-2% band has been officially notified. Presumably owing to this, the MPC found room to cut rates even though RBI staff projections are of a 4.5% CPI in Q4 2017 – 18 (it is to be noted that even this 4.5% number doesn’t include the direct or indirect impact of the house rent component of 7th Pay commission). However, some amount of confusion in the analyst community has persisted; and this seems chiefly owing to the following: in theory an inflation target band should work towards ensuring that cyclical / event related shocks can be absorbed without the central bank having to react in terms of drastic changes to its policy setting. Thus for instance if our average CPI was indeed trending towards 4%, the RBI could have been assured that even in the case of an adverse event like an oil price spike or a monsoon shock, inflation could have been contained within the 6% outside limit. Instead, the central bank seems to be expressing comfort effectively with a CPI between 4 – 6% even when we are experiencing significant cyclical disinflation currently. Today we are experiencing the beneficial price effect of a good monsoon even as rural wages still remain depressed, the full effect of centre and state pay awards and consequent consumption thrust is still ahead of us, and global commodities are still relatively depressed. Even with these strong cyclical tailwinds if the centre point of the CPI band is unachievable and the central bank remains in easing mode, there is possibly a case to wonder what happens down the road. The argument then is not whether the RBI is unjustified in pursuing the range rather than the mid-point. It is rather this that if at probably peak cyclical disinflation we still cannot think about the mid-point, then what probability do we have of defending the range over longer periods of time. This is especially true when, as RBI’s own surveys indicate, household inflation expectations remain exceptionally volatile. A related point, made recently by some economists, is with respect to the appropriate reaction function of an inflation targeting central bank. Again the theory goes that the central bank should only respond to near term or recent history inflation prints, if those prints contain some information about the likely trajectory of inflation over the medium term. It is worth examining the recent inflation trends from this standpoint. It is now well documented that despite a collapse in rural purchasing power and excess industrial capacity, our so called core part of CPI (excluding all components of food and fuel) has persistently refused to budge below the 5% handle. Instead the bulk of disinflation last month and what is expected in the months ahead, is coming from massive actual and expected disinflation in pulses and vegetables. The problem is that if farmer realization on pulses is allowed to collapse like this, the incentive to grow will diminish next year and prices will rise again on shortage. Indeed, the plan seems to be to continue to raise minimum support prices (MSP) on pulses and step up procurement to both build buffers and protect farmer realization so that there is no avenue for shortage down the line. Hence, there seems to be little information in the current bout of disinflation on what prices may be in the future. For this reason, some believe that it may be inappropriate for RBI to act based on ‘opportunistic’ episodes of disinflation. Instead these may be used to create further disinflation buffers so that unwinding of these triggers down the line don’t invite an adverse reaction function from a CPI targeting RBI.
 
2. The concept of ‘real’ rates: Under the Rajan era, and after many iterations, the real rate framework broadly got defined as the rate on 1 year treasury bill minus average expected inflation. The RBI’s preference then was said to be 1.5 – 2% real rate. This has been tweaked by the new regime which says that, given global realties of lower real rates, one can even target a lower real rate of 1.25%. Now there seem to be two problems with respect to executing this framework: One, it is difficult for the RBI to target a particular level of CPI while simultaneously giving out a real rate guidance. Thus under Rajan if the RBI was serious about achieving the 4% target but wasn’t confident about it going there, it certainly couldn’t have afforded to cut rates further; even though had that target been achieved the real rates in the system would have been much higher than the guidance band of 1.5 – 2%.  This problem is less difficult in the new regime since, if the RBI is targeting an inflation range rather than a point, it has more flexibility to honor both the range as well as the real rate target. However, this convenience may not exist down the line when cyclical disinflationary pressures have run their course. Two, CPI in India is still very volatile and extremely difficult to predict into the future. This is evident from the width of the RBI’s own fan-chart on CPI projections. In such a circumstance, a real rate guidance based on future average expected inflation can get very tricky. To take an actual example, the market expects CPI prints over the next 6 months to substantially undershoot RBI’s assessed trajectory. If this were to happen, there is a strong likelihood that participants start expecting delivery of 1.25% real rates over these ‘seasonally depressed’ CPI prints. Indeed, it is possible that such expectations have already begun taking hold. It then becomes very difficult for RBI to guide commentary, if future inflation prints revert closer to what is the more persistent underlying trend. This, then, is the potential hazard of putting in public domain an at best nebulous concept, as a guiding factor for future policy expectations.
 

Investor Takeaways

 

The RBI is certainly well within its rights to re-interpret its mandate with a change in regime. The point here has been only to point out some aspects of this re-interpretation and potential outcomes down the line. For investors, the takeaways from our stand-point are these: It makes sense to position for continued near term bullishness given 1>that near term CPI prints are probably poised to fall much more than is being projected by RBI staff, 2> it seems reasonably clear that the new regime has chosen to interpret the FIT mandate more benignly. However, there do remain two points of caution: One, there is a chance that the global environment turns more volatile with some doubts cropping up on further G3 easing as well as with event risks like the US elections around the corner. If heightened volatility indeed comes to pass, then India being an emerging market will have to weather its own share of volatility. Two, as risk free and AAA rates fall further investors shouldn’t continually dilute their risk filters in an attempt to secure better yields for their portfolio. Rather, first the level of desired risk should be ascertained and then portfolio decisions should be made; even if this means somewhat lower returns than recent history.

 

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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Suyash Choudhary

The RBI cut rates by 25 bps, taking repo to 6.25%. This was broadly consistent with the direction of policy that almost all participants in

the market were anticipating, although timing of the next cut was being debated about. The following are our chief takeaways from the policy and the subsequent press conference. Please note that RBI and monetary policy committee (MPC) may sometimes be used interchangeably here.

 
1. The RBI is more worried about global growth on the margin. However, local growth prospects appear brighter owing to stronger agricultural growth and rural demand, as well as because of the urban demand stimulus from the pay commission.
 

2. Near term CPI inflation outlook is expected to turn further benign, owing largely to a downshift in food inflation. Alongside better sowing on the back of good monsoons, the government’s efforts are also expected to aid the inflation trajectory going forward. However, the statement notes that ‘this has opened up space for policy action, as indicated in the third bi-monthly monetary policy statement’. This seems to indicate that the space opened up owing to good monsoons and the government’s deft supply side response has already been used.
 
3. The MPC has noted potential cost push pressures that may emerge, including the 7th pay commission award’s effect on house rent allowances (HRA), and increase in minimum wages with possible spill over through minimum support prices (MSP). Interestingly, the accompanying monetary policy report notes that while the direct effect of HRA in CPI should be overlooked, ‘model simulations indicate that the indirect effects arising out of aggregate demand effects and rise in inflation expectations may require a tightening of the monetary policy stance to ensure that inflationary pressures from this factor do not get generalized and entrenched into expectations’.
 
4. The RBI staff’s baseline projection takes CPI down from 5.7% in Q1 2016 – 17 to 5% in Q3, before it firms up moderately to 5.3% in Q4. Reflecting this the MPC retains upside risk to 5% by March 2017; although it acknowledges that the risks are lower than those assessed in the past 2 monetary policy statements. Also importantly, the RBI staff assesses that CPI will fall over 2017 – 18, and reach 4.5% by Q4 of 2017 – 18.  However, these forecasts don’t take into account the direct and indirect effect of HRA which, under assumptions of full implementation first by centre and then by states, can impart a 100 – 150 bps upward pressure to baseline forecasts. Also, this impact can sustain for 6 – 8 quarters, as per the analysis in the monetary policy report.
 
5. In the press conference, when asked on real rates, Dr. Patra indicated that after today’s action it has been brought down to 1.5% (1 year treasury bill yield minus average inflation expectation). Given global trend of lower real rates, there is scope to bring this further down to 1.25%.
 

Interpretation and Way Forward

 

There is a strong likelihood that the RBI is still over-estimating the near term CPI trajectory (upto March 2017). Continuous undershoots in actual prints may lead them to cut rates one more time. Having said that, most of the ‘cost push’ factors being talked of will potentially manifest over the next 6 – 9 months. It will then really boil down to whether the RBI chooses to use the ‘window’ from near term inflation prints, or exercises caution to assess potential risks from medium term events. There is certainly some flexibility in this assessment, especially since the new Governor Patel categorically mentioned that the self imposed target of 4% existed before the 4+/-2% target had been officially notified. An important ingredient into the decision will also be the state of global risk, especially after the outcome of the US Presidential elections in November.

 

From a market standpoint, most participants will look out for one last rate cut; but may be unsure of its exact timing. Consistent lower inflation prints in October and November (our base case) and a stable global risk outlook may keep expectations of a December cut alive. Alternatively, the expectation may be pushed outwards. The other large trigger for the market is the prospect of continuous OMOs. At the current juncture, the so-called core liquidity is in surplus of around INR 1,25,000crores. However, the system will lose almost all of this by December on account of currency leakage. Any dollar shortfall over FCNR will constitute additional shortage. Then over Jan – March, another INR 1,00,000crores will bleed out on currency leakage; potentially offset partially by net dollar accretion assuming a stable global sentiment. All told, we would expect another around INR 75,000 crores of OMOs from here till March.

 

The yield curve has started to steepen again for the last few days; and quite appreciably so after the RBI policy today. We believe this is logical owing to the following factors:

 
1. Limited expectation of further easing with some amount of timing uncertainty: this may lead participants to focus on the actual cost of funding (thus helping the short end)rather than a potentially lower cost of funding in the future (helps long duration).
 
2. OMOs may run with more predictability given starting point of INR 1,25,000crores liquidity. This is against the bunched up OMOs that we saw earlier in the year.
 
3. Supply of state loans is set to rise between now and March, thereby adding to supply of ‘investor assets’ alongside long end bonds.
 

Given these, and after having tactically played both 14 – 15 year government bonds and state loans over the past 2 months, we had reverted to our preferred segment of 5 – 9 year rates going into this policy. Our current overweight is 7 – 9 years which provides sufficient participation in a gradual yield drift down and will benefit from incremental curve steepening. Investors should prefer active duration and short / medium term fund as offering best risk-reward.

 

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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