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Investment Insights

Suyash Choudhary

Fixed Income Themes for 2017

By: Punam Sharma

The year gone by started pessimistically but on balance proved to be quite a rewarding one for fixed income. A complete turnaround in RBI liquidity philosophy leading to quantum bond purchase from the market, Rajan and Britain exits triggering expectations of more monetary easing locally and globally, and finally demonetization resetting RBI rate cut expectations; all played their parts in the continuing bond rally over the year. Towards year end, however, uncertainties have picked up again. The global rate environment has reset meaningfully on expectations of a more pro-active fiscal policy, chiefly in the US. Meanwhile, the macro-gains expected from India’s demonetization exercise seem a little less clearer now and the RBI seems to have taken on a much more hawkish tone than anticipated, causing much more wariness amidst market participants towards the close of the year.

 

The emphasis here always has been to rely less on deterministic ‘level’ based views and more on underlying frameworks that inform allocation decisions. Towards this same objective, we highlight in this note some of the key themes that we think are likely to shape the bond view over 2017.

 
1. The net stimulus from Trump policies: The global ‘re-rating’ in bond yields has been largely on expectations that the baton of growth is being passed from monetary to fiscal policy, especially in the US. Trump has proposed an aggressive tax cut agenda while the Speaker of House of Representative Paul Ryan is also working on a plan to adopt a ‘consumption-based approach’ to taxation; in addition to rationalizing tax slabs. If implemented quickly and effectively, and not accompanied by other facets of policy which are growth destructive, this could prove to be a magnet for flow back into the US. To the extent that this is accompanied with continued dollar strength, emerging market economies including India will need to be that much more watchful about their own macro-stability.
 
2

 
While on the subject of global financial stability risks, a matter also on the mind of Governor Patel as seen in the latest minutes of monetary policy, it is useful to see what exactly one has to be wary of. A lot of concern gets expressed about the narrowing interest rate differential between US and India. While no doubt a higher rate differential also serves to attract flows into an emerging market, history has shown that if the narrowing differentials are on account of sound macro-economic logic, they can be sustained. The first graph above tracks India – US rate differential versus our inflation differential since 2001. As can be seen, over periods where inflation differentials are falling/lower we have been able to sustain less than the current rate differential of 400 bps. Indeed if the recent narrowing of inflation differentials sustain there is no reason to expect, ceteris paribus, that rate differentials should necessarily widen. In the second graph, we introduce current account deficit (CAD) as another variable in assessing determinants of rate differentials. Again it can be seen that in periods of low CAD, it has been easier to sustain lower rate differentials. This makes intuitive sense as well since a lower CAD implies a lower savings – investments gap and hence a lower reliance on offshore flows. This again is a condition that is being met currently. Ultimately, the key to sustaining differentials, assuming current lower ranges of inflation and CAD domestically, may depend upon the behavior of the US dollar. As the line graph in the second chart also shows, INR was broadly appreciating during the 2002 – 08 period when we sustained narrowed rate differentials. However, if in the period ahead US dollar continues to strengthen then foreign investors may well demand a larger rate differential to still be interested in Indian rates.

 
2. The policy response to demonetization: The narrative from India’s demonetization move is ‘short term pain for longer term gains’. There’s no denying the pain being felt by large sections of cash intensive India, which covers almost all of the economically vulnerable population; including farmers and unorganized manufacturing and trade. For the narrative to be complete, the gains need to be made visible after the end of the exercise. These no doubt include curbing counterfeits and black money, and increasing the tax base as well as digitization habits of the population. However, implicit here is also a promise of allocation transfer towards the vulnerable. This last will need to happen via explicit fiscal policies of the government. Apart from the welfare standpoint, there is a macro-economic way to think of this as well. There are four drivers of aggregate demand: consumption (C), investments (I), government spending (G)and net exports (X-M). Out of these, ‘C’ is what has reliably worked for India with some degree of resilience. ‘I’ has been weak, and had turned weaker lately as the Q2 GDP data showed us. ‘X-M’ has lately started rebounding but will be subject to global factors much outside our policy control. ‘G’ has stepped up in terms of quality, but is constrained by deficit targets. Now, post demonetization the hitherto reliable leg, ‘C’ has taken a knock; at least temporarily. The only discretionary lever that can compensate for this in the near term is ‘G’ or government spending. To be clear, it is very unlikely that the government will embark upon any sort of ‘fiscal adventure’; especially given the credibility it has built thus far on macro-stability. However, equally, there seems to be little case for further meaningful fiscal compression from here-on, absent other discretionary drivers of growth.
 

The other policy lever is of course with RBI. Indeed, post demonetization announcement it had looked very likely that RBI will deploy more easing; especially as the tone of the monetary policy committee (MPC) seemed decidedly dovish and growth oriented in the October policy. However, and as  was revealed in greater detail in the minutes of the December policy, there seem to be 5 commonalities in the current thinking of most members of the MPC: 1> They are awaiting more transmission of rate cuts done so far into bank lending rates. This may start happening from January, going by recent media reports. 2> They expect effects of demonetization to be transitory. 3> They seem quite worried about global financial risks. 4> The medium term target of 4%, the mid-point of notified CPI target range, is back in play. 5> There is worry on stickiness of core inflation. While an undershoot of near term growth and CPI from RBI’s assessed ranges may well still invite  rate cuts, the bar for these has been decidedly set higher compared with market’s initial expectations.

 
3. RBI’s neutral liquidity framework: The liquidity dynamics of the banking system have been straightforward thus far: there has been annual leakage of currency into the hands of public in excess of INR 2,00,000 crores annually. Given also a starting point of financial year of net negative liquidity, this has provided RBI with a comfortable framework where it can expand its balance sheet and create reserve money while simultaneously ensuring that overall system liquidity remains neutral. This equation may get tricky going forward. Not only may there be significant liquidity left over getting into the new financial year, but the pace of currency leakage may also diminish substantially going forward given the behavioral changes anticipated post demonetization. This may reduce the need for substantial bond buy backs from the RBI in the year ahead, assuming no large external shock that leads to massive foreign capital drain. At some juncture, as demand for credit picks up, the RBI may have to start to focus again on ensuring enough reserve money gets created to service the ‘legitimate’ demands of the economy.
 

From a bond market standpoint, the importance of bond purchases by RBI cannot be underplayed; especially as foreign investor demand is also likely to be uncertain in the year ahead. The graphs below help illustrate the significant bond supply lined up in the financial year ahead. There are two elements that bear watching here: One, we are now entering a phase where for the next few years government bond maturities are higher than the recent past run-rate. This is despite bond buybacks done by the government. This matters since, while net supply may not change much, new issuances of bonds add duration to the market. Two, the supply of state development loans (SDL) is picking up appreciably, even outside of the so-called UDAY bonds.

 

1

 

As can be seen in the line graph above, gross supply ex of UDAY and corporate bonds is slated to pick up appreciably. Assuming no support from RBI bond purchases, even the net supply will rise quite meaningfully.

 

Conclusions
 

The intent here has been more to lay out the broad framework around which one can seek cues for the bond market, rather than provide a deterministic view of shape of things to come. The reason for this really is that markets are in a bit of a ‘data vacuum’ for some time now; both with respect to local as well as global events. Thus locally the full effects of demonetization on growth are still unfolding whereas globally one waits to see with what speed and efficacy the new US administration’s fiscal policies get implemented. Indian bonds were interpreting the data vacuum bullishly post demonetization but have since turned more cautious. This is basis a more hawkish RBI and Fed compared with expectations. However, if the local growth shock on incoming data proves to be deeper and / or the Trump fiscal plan underwhelms, markets may very easily revert to a dovish interpretation all over again. From the perspective of Indian bonds, a meaningful rally from here has to be predicated on either one of two things: 1>Market bringing back expectations of more than 25 bps rate cut in the near term; or 2> Bond supply assumptions get changed basis final fiscal gains from demonetization. One will have to continually assess the likelihood of these in context of the overall themes as described above, and accordingly adjust the investment risk being taken. From an investors’ standpoint, the banking system is probably providing the best indicator for course of action. Given the hugely positive ‘wedge’ between deposit and credit growth, banks are unlikely to chase aggressive deposits for most of the year ahead. This should serve as a large incentive / trigger for fixed income investors to plug reinvestment risks via products that are suited to their duration and credit risk profiles. The level of risk can be adjusted in the future as more data comes in to feed the framework.

 
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.

Tag:

Suyash Choudhary

The year gone by started pessimistically but on balance proved to be quite a rewarding one for fixed income. A complete turnaround in RBI liquidity philosophy leading to quantum bond purchase from the market, Rajan and Britain exits triggering expectations of more monetary easing locally and globally, and finally demonetization resetting RBI rate cut expectations; all played their parts in the continuing bond rally over the year. Towards year end, however, uncertainties have picked up again. The global rate environment has reset meaningfully on expectations of a more pro-active fiscal policy, chiefly in the US. Meanwhile, the macro-gains expected from India’s demonetization exercise seem a little less clearer now and the RBI seems to have taken on a much more hawkish tone than anticipated, causing much more wariness amidst market participants towards the close of the year.

 

The emphasis here always has been to rely less on deterministic ‘level’ based views and more on underlying frameworks that inform allocation decisions. Towards this same objective, we highlight in this note some of the key themes that we think are likely to shape the bond view over 2017.

 
1. The net stimulus from Trump policies: The global ‘re-rating’ in bond yields has been largely on expectations that the baton of growth is being passed from monetary to fiscal policy, especially in the US. Trump has proposed an aggressive tax cut agenda while the Speaker of House of Representative Paul Ryan is also working on a plan to adopt a ‘consumption-based approach’ to taxation; in addition to rationalizing tax slabs. If implemented quickly and effectively, and not accompanied by other facets of policy which are growth destructive, this could prove to be a magnet for flow back into the US. To the extent that this is accompanied with continued dollar strength, emerging market economies including India will need to be that much more watchful about their own macro-stability.
 
2

 

While on the subject of global financial stability risks, a matter also on the mind of Governor Patel as seen in the latest minutes of monetary policy, it is useful to see what exactly one has to be wary of. A lot of concern gets expressed about the narrowing interest rate differential between US and India. While no doubt a higher rate differential also serves to attract flows into an emerging market, history has shown that if the narrowing differentials are on account of sound macro-economic logic, they can be sustained. The first graph above tracks India – US rate differential versus our inflation differential since 2001. As can be seen, over periods where inflation differentials are falling/lower we have been able to sustain less than the current rate differential of 400 bps. Indeed if the recent narrowing of inflation differentials sustain there is no reason to expect, ceteris paribus, that rate differentials should necessarily widen. In the second graph, we introduce current account deficit (CAD) as another variable in assessing determinants of rate differentials. Again it can be seen that in periods of low CAD, it has been easier to sustain lower rate differentials. This makes intuitive sense as well since a lower CAD implies a lower savings – investments gap and hence a lower reliance on offshore flows. This again is a condition that is being met currently. Ultimately, the key to sustaining differentials, assuming current lower ranges of inflation and CAD domestically, may depend upon the behavior of the US dollar. As the line graph in the second chart also shows, INR was broadly appreciating during the 2002 – 08 period when we sustained narrowed rate differentials. However, if in the period ahead US dollar continues to strengthen then foreign investors may well demand a larger rate differential to still be interested in Indian rates.

 
2. The policy response to demonetization: The narrative from India’s demonetization move is ‘short term pain for longer term gains’. There’s no denying the pain being felt by large sections of cash intensive India, which covers almost all of the economically vulnerable population; including farmers and unorganized manufacturing and trade. For the narrative to be complete, the gains need to be made visible after the end of the exercise. These no doubt include curbing counterfeits and black money, and increasing the tax base as well as digitization habits of the population. However, implicit here is also a promise of allocation transfer towards the vulnerable. This last will need to happen via explicit fiscal policies of the government. Apart from the welfare standpoint, there is a macro-economic way to think of this as well. There are four drivers of aggregate demand: consumption (C), investments (I), government spending (G)and net exports (X-M). Out of these, ‘C’ is what has reliably worked for India with some degree of resilience. ‘I’ has been weak, and had turned weaker lately as the Q2 GDP data showed us. ‘X-M’ has lately started rebounding but will be subject to global factors much outside our policy control. ‘G’ has stepped up in terms of quality, but is constrained by deficit targets. Now, post demonetization the hitherto reliable leg, ‘C’ has taken a knock; at least temporarily. The only discretionary lever that can compensate for this in the near term is ‘G’ or government spending. To be clear, it is very unlikely that the government will embark upon any sort of ‘fiscal adventure’; especially given the credibility it has built thus far on macro-stability. However, equally, there seems to be little case for further meaningful fiscal compression from here-on, absent other discretionary drivers of growth.
 

The other policy lever is of course with RBI. Indeed, post demonetization announcement it had looked very likely that RBI will deploy more easing; especially as the tone of the monetary policy committee (MPC) seemed decidedly dovish and growth oriented in the October policy. However, and as  was revealed in greater detail in the minutes of the December policy, there seem to be 5 commonalities in the current thinking of most members of the MPC: 1> They are awaiting more transmission of rate cuts done so far into bank lending rates. This may start happening from January, going by recent media reports. 2> They expect effects of demonetization to be transitory. 3> They seem quite worried about global financial risks. 4> The medium term target of 4%, the mid-point of notified CPI target range, is back in play. 5> There is worry on stickiness of core inflation. While an undershoot of near term growth and CPI from RBI’s assessed ranges may well still invite  rate cuts, the bar for these has been decidedly set higher compared with market’s initial expectations.

 
3. RBI’s neutral liquidity framework: The liquidity dynamics of the banking system have been straightforward thus far: there has been annual leakage of currency into the hands of public in excess of INR 2,00,000 crores annually. Given also a starting point of financial year of net negative liquidity, this has provided RBI with a comfortable framework where it can expand its balance sheet and create reserve money while simultaneously ensuring that overall system liquidity remains neutral. This equation may get tricky going forward. Not only may there be significant liquidity left over getting into the new financial year, but the pace of currency leakage may also diminish substantially going forward given the behavioral changes anticipated post demonetization. This may reduce the need for substantial bond buy backs from the RBI in the year ahead, assuming no large external shock that leads to massive foreign capital drain. At some juncture, as demand for credit picks up, the RBI may have to start to focus again on ensuring enough reserve money gets created to service the ‘legitimate’ demands of the economy.
 

From a bond market standpoint, the importance of bond purchases by RBI cannot be underplayed; especially as foreign investor demand is also likely to be uncertain in the year ahead. The graphs below help illustrate the significant bond supply lined up in the financial year ahead. There are two elements that bear watching here: One, we are now entering a phase where for the next few years government bond maturities are higher than the recent past run-rate. This is despite bond buybacks done by the government. This matters since, while net supply may not change much, new issuances of bonds add duration to the market. Two, the supply of state development loans (SDL) is picking up appreciably, even outside of the so-called UDAY bonds.

 
1

 

As can be seen in the line graph above, gross supply ex of UDAY and corporate bonds is slated to pick up appreciably. Assuming no support from RBI bond purchases, even the net supply will rise quite meaningfully.

 

Conclusions

 

The intent here has been more to lay out the broad framework around which one can seek cues for the bond market, rather than provide a deterministic view of shape of things to come. The reason for this really is that markets are in a bit of a ‘data vacuum’ for some time now; both with respect to local as well as global events. Thus locally the full effects of demonetization on growth are still unfolding whereas globally one waits to see with what speed and efficacy the new US administration’s fiscal policies get implemented. Indian bonds were interpreting the data vacuum bullishly post demonetization but have since turned more cautious. This is basis a more hawkish RBI and Fed compared with expectations. However, if the local growth shock on incoming data proves to be deeper and / or the Trump fiscal plan underwhelms, markets may very easily revert to a dovish interpretation all over again. From the perspective of Indian bonds, a meaningful rally from here has to be predicated on either one of two things: 1>Market bringing back expectations of more than 25 bps rate cut in the near term; or 2> Bond supply assumptions get changed basis final fiscal gains from demonetization. One will have to continually assess the likelihood of these in context of the overall themes as described above, and accordingly adjust the investment risk being taken. From an investors’ standpoint, the banking system is probably providing the best indicator for course of action. Given the hugely positive ‘wedge’ between deposit and credit growth, banks are unlikely to chase aggressive deposits for most of the year ahead. This should serve as a large incentive / trigger for fixed income investors to plug reinvestment risks via products that are suited to their duration and credit risk profiles. The level of risk can be adjusted in the future as more data comes in to feed the framework.

 

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.

Tag:

Suyash Choudhary

The RBI policy surprised most in the market, in that not only did the central bank not cut rates (an outcome expected by a minority) but actually came out sounding quite a bit hawkish. Key takeaways were as follows:

 
1. Growth outlook for the current year is uncertain with the demonetization; especially since there was already a 50 bps momentum loss after Q2. There are broadly 2 channels of effect that RBI sees: a) short run disruption in economic activity in cash intensive sectors, b) aggregate demand compression associated with adverse wealth effects. It assesses, however, that impact of first will ebb once cash in circulation improves and non-cash based payment instruments gain greater usage. Whereas, the compression on account of wealth effect is ‘likely to be limited’. On net, GVA growth for FY 17 is revised from 7.6% to 7.1% with evenly balanced risk.

 
2. On CPI, the committee ‘took note’ of upturn in prices of several items that is masked by easing on the back of base effects.  There is acknowledgement that demonetization could push down prices of perishables in the next CPI print. However, prices of wheat, gram, and sugar have been firming up. Moreover, they assess that impact of slowdown of discretionary consumption on the goods and services component of CPI (16% of basket) may also be transitory. Prices of another large component of CPI comprising housing, fuel, health, transport etc comprising 38% of the basket may remain largely unaffected. General upside risks may emerge if winter moderation to food prices doesn’t transpire owing to disruptions, or from the usual suspects: crude and rupee. All told, Q3 inflation may fall by 10 – 15 bps, but the headline CPI for Q4 2016 – 17 is retained at 5% with still upside risks; although lower than that in October.
 

In summary the accommodative stance is retained but the committee judges it ‘prudent to wait and watch how these factors play out and impinge upon the outlook’. The policy decision was unanimous. Furthermore, the adhoc incremental CRR has been withdrawn now that MSS ceiling has been hiked to INR 6,00,000crores.

 

Takeaways:

 

The outcome today is surprising not because a strict CPI targeting central bank shouldn’t behave this way. In point of fact, a CPI targeting bank should consider each incremental event from standpoint of sustainability of desired disinflation and accordingly act. This is largely what the MPC seems to have done today. The surprise rather is that basis the previous policy and the minutes thereof it had seemed quite evident that so long as CPI is in a range which is amenable to the MPC, the focus was on arresting the growth slowdown. Indeed, Dr. Patel had taken pains to take market attention away from the 4% target, saying that this target was no longer valid as the official range now was 4+/-2%. Additionally, rather than focusing on comfort with respect to incremental disinflation, it seemed that the RBI was preparing us for further cuts on justification that the so-called real rate can be brought down to 1.25% from the 1.5 – 2% band earlier. Now with an indeterminate growth shock, one would have assumed that this framework would have allowed for further dovishness. Instead, the MPC seems to have suddenly reverted to only focusing on sources of further sustainable disinflation. The fact that they are able to make this switch in a uniform voice (no dissents in either policy) makes this probably even more remarkable.

 

Market has been clearly taken aback with the decision today, leading to aggressive paring of risk positions in the market. Indeed, it may take some time for the dust to settle down. However, once it does, investors need to keep the following points in view:

 
1. The RBI today has perhaps been a shade too deterministic since effects around the demonetization program are still yet unfolding. This comment addresses not the lack of rate cut but only the switch to relative hawkishness in an environment where the growth (and indeed) inflation effect of the exercise is still indeterminate. Therefore, it stands to reason that if the effects sustain and lead to lower than expected growth and a greater than expected CPI impact, the RBI would also switch back to a dovish reaction function. Thus for instance and to take just one aspect of this, property prices have yet not fallen. Transactions have merely dried up. So it is as yet difficult to anticipate the wealth effect erosion and hence impact on discretionary consumption.
 
2. Unlike macro events that only require an ‘expectations’ re-pricing, this one has direct implications on bank deposit rates and so forth. Thus whatever the gyrations in 10 year bond yields, it is likely that investors will not get seasonally higher FD rates this year, as they typically do during Jan – Mar every year. Therefore, the need to plug reinvestment risk in line with risk appetite is very much relevant; notwithstanding the rate decision today.
 
In summary, and as detailed in a recent note (refer “The Importance of What We Don’t Know: A Bond Market Update, dated 2nd December), we alongside the RBI simply don’t have enough information yet to make deterministic calls on the full macro-effects of the demonetization exercise. However, from what we do know, the imperative to plug reinvestment risk via elongating maturity is clear. This elongation has to be in line with underlying risk appetite since this will give investors the wherewithal to absorb days like today. We reiterate, however, that RBI’s interpretation today will evolve as well as more information is available on the extent of damage. Given this, we would not be excessively biased by the outcome of policy today.

 

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.

Tag:

Suyash Choudhary

A lot has happened both globally and here in India over the past month. Globally, the incipient expectations that the burden of shouldering growth may somewhat start shifting towards fiscal policy from purely monetary easing hitherto got a decided leg up with Trump’s election to the US presidency. Led by a US sell off, global yields have also backed up considerably. Contrasting this to India, the demonetization exercise has fuelled a 50 bps rally in bonds during the same period. Both these sets of events have understandably thrown up a variety of views to process for investors. Given the scale and complexity of each, it is a given that impact analysis from these will be continually evolving. Meanwhile, however, investors still need to allocate as the market continues to move fast. As much as there is risk on acting on too little information there is also a risk here of waiting for too much information, or alternatively, give out deterministic ‘target price/level’ based views.

 

What We Know

 

1. Locally, the demonetization exercise is likely to have three major channels of impact:
 
a. Growth will be hit at least for the next few months, as discretionary consumption suffers and money velocity stalls. This, alongside a temporary collapse in prices of perishables, will also affect CPI but possibly to a lesser degree. These have potential to increase the number of rate cuts still left on the table, versus what was before.
 
b. The banking system is receiving a deluge of deposits with total deposits having already crossed INR 11,00,000crores as per some reports. Against this, around 25% is ‘leaking’ back as cash so far. But this proportion is likely to improve as printing of new notes gains further steam.
 
c. The government is likely to get some tax revenues as at least some part of the deposit inflow ultimately gets admitted to as previously undisclosed income. There is also a chance that residual amounts left in the old currency beyond a later cut-off date get de-legalized; leading to a windfall for the RBI.
 
2. RBI’s stated intent is to keep overnight rate as close to the repo rate as possible. Apart from using monetary tools like CRR, it has government bonds worth INR 7,50,000crores to absorb liquidity from the system. When the scale of deposit flow started picking up meaningfully, the RBI moved to temporarily hike CRR thereby impounding INR 3,25,000crores. Had it not done this, it may have risked falling short on its absorptive capacity for incoming liquidity. This would have led to overnight rates collapsing much below the repo rate; a scenario RBI would have not wanted. Now that MSS bond ceiling has been hiked to INR 6,00,000crores the RBI total absorptive capacity has moved to INR 13,50,000 crores.  This will allow it to unwind the temporary CRR with no risk that it will fall short on absorptive capacity till the end of the demonetization exercise. Thus market’s panic first on announcement of CRR and then on expansion of MSS ceiling is largely unjustified, since these are strictly operational exercises aimed at keeping overnight rates close to repo rates.
 
3. Globally, with the recent rise in the dollar and US bond yields relative to many peers, relative financial conditions have tightened in the US without the Fed having done any incremental hiking. Ordinarily, this itself should have led the Fed to backtrack on its rate hike intentions; though this may not be the case this time around. However, given the scale of dollar leverage creation around the world over the past few years, if dollar and dollar rates continue to climb it is only a matter of time that country and company financials around the world start to wobble again; similar to what happened in 2015. This in turn should act as an auto-stabilizer for the one-way divergence of financial conditions in the US versus the rest of the world.
 
What we Don’t Know
 
1. There are definitive numbers being put around the extent of growth damage. Some of these are getting derived from the monetarist equation of MV=PY, which basically equates money supply and its velocity to the nominal value of output. Some of these are from grounds up anecdotal evidence of how participants in certain sectors have suffered. The simple point is given the scale of the demonetization exercise and its potential wide ranging impacts, it is very hard yet to attribute a range to GDP growth hit.
 
2. It is also difficult to estimate what proportion of incoming bank deposits finally stick on with the system, and what leaks out again once new notes come into circulation fully. Indeed, bankers themselves are divided with some expecting 50% conversion, and some not more than 10 – 15%.
 
3. Similarly, while as stated above there is a sense of fiscal improvement, it is difficult to gauge by how much. The scale of deposits so far has far exceeded most estimates thereby leading to some disappointment in certain quarters that the extent of black economy cleansing may be considerably lower than earlier envisaged. Hence, the extent of RBI ‘windfall’ on eventual notes extinguishment may also be thus lower. However, it is likely that over the next months the government starts investigating the deposits that it finds suspicious and thereafter starts penalizing them under the contours of the new scheme that has been recently announced (almost 50% taxed, 25% in 4 year non-interest bearing account, 25% returned). Against this, there will be some set back on tax collection simply from the slowdown in economic activity and property sales. The net effects of these, and when and how much and by what procedure RBI is ultimately able to realize its windfall, will also take a lot of time to unfold.
 
4. While the US president in waiting has an aggressive fiscal agenda on paper, we don’t yet know whether and over what time it gets fully translated into actual spending. There are conservative Republicans in the system as well who will need to be taken on board with respect to the fiscal costs of such an exercise. Additionally, if the other pillar of aggressive trade re-negotiations is pursued as well, then the net impact on US growth and hence US monetary policy may turn out to be more muted than some are currently envisaging. At any rate, the underlying long period macro themes of over-leverage, falling productivity, and aging demographics which are all growth destructive are unlikely to be reversed for years ahead. The point here is that the Fed has to conduct monetary policy in the here and now in the face of aggressively tightening financial conditions, while the contours of the actual government policy change that may potentially lead it to change its reaction function are still sufficiently vague and in the future.
 

Investor Implications    
 

It is clear from the above, that what we know is sufficient for now to inform our action as investors: a more dovish RBI on margin, better system liquidity, and abatement of future fiscal risks are all positive for rates. Basis these, investors should at least plug reinvestment risks as the seasonal uptick in rates that one normally associates with January – March may not be forthcoming this year.For the rest, whether the choice is of short/medium term or active long term funds or a combination of both really depends upon the relative appetite to handle short term volatility. However, an examination of what we don’t know is almost equally important as well. In the first phase after the demonetization, while what we knew was enough to action investments, a lot of time was spent on the operational details around what we don’t know; the biggest being whether or not government via the RBI can appropriate the windfall. In the current phase, the CRR hike and MSS chatter triggered a lot of debate; whereas from what we know it is clear that the RBI should be net dovish after this exercise and these tools are merely operational to absorb the excess liquidity.

 

On another note, one comes across deterministic views in the market on extent of growth shock, number of rate cuts, and targets on 10 year government bond yields. To the extent that these are merely tools to communicate the urgency to invest basis the event of demonetization, they may make sense. However, what is really required currently is just an understanding that the balance of macro shifts require investors to elongate investments and continue participating. It is possible that if the growth shocks turns out to be significant enough and if global yields stabilize, there is an out-sized reward left on the table. Conversely, the reward may be less exciting.  Either way this doesn’t change the action that investors need to take today (and indeed since the day post the de-monetization), of elongating maturities depending upon their risk profiles.

 

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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