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Investment Insights

Suyash Choudhary

The last few weeks have seen quite a few developments both locally and globally. We take a closer look at some of these in this note, in context of our underlying current framework for bond markets.

 

1. Escalation in geo-political risks: Global markets finally caught a risk off flavor, at least briefly, as the war of words between the US and North Korea got more intense. Adding to this locally was some jitter with respect to a stand-off between India and China. Risk markets gave off and the rupee suffered over this period; though at the time of writing the perception with respect to the situation seemed more stable. From a view standpoint there is little one can do to build in potential events like these, whose fructification can be of intense magnitude but has to be assigned a very low probability. The more durable macro-theme with respect to prospects of rise in global financial risks is whether G3 inflation is about to pick up or not. In this regard, the latest US CPI data also printed weak and so the narrative continues for now that inflation proves elusive. However, this debate is likely to remain ripe till activity indicators remain relatively strong in these markets.
 

2. Heightened concern on Indian private sector growth: The key take-away from the recently released ‘Economic Survey Volume II’, is the stark flagging of ‘near-term deflationary impulses’ that ‘reign over the Indian economy’. The concern with respect to the slowing private sector growth is quite visible with the RBI in the latest monetary policy review as well. However, the chief economic advisor (CEA) seems much more concerned and provides a lot more detail on the subject. Thus, the economic survey notes that the deflationary impulses currently are on account of 1> stressed farm revenues, as non-cereal food grain prices have fallen sharply, 2>fiscal tightening by states to keep deficits in check in context of farm waivers, 3> declining profitability in power and telecom sectors further accentuating the twin balance sheet issue, and 4>transitional frictions from implementation of GST. Quite interestingly, and counter to conventional wisdom on the matter, the CEA analyses that the current spate of farm loan waivers could reduce aggregate demand by up to 0.7% of GDP if implemented in full.

 

The concerns expressed by the RBI and, more vocally, by the CEA are quite legitimate as seen in the graph below of the core GVA growth (GVA stripped of agriculture and government). Not only is the current state alarming but, as we will examine below, there doesn’t seem to be any meaningful near term trigger on the horizon that can potentially reverse this trend.

 
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3. RBI’s lesser dividend to GOI: The RBI has paid only INR 30,659 crores as dividend to the government this year. This is almost INR 35,000 crores lesser than the year before. While the government would have anticipated some slowdown in RBI dividend owing to demonetization related costs (RBI paying interest under reverse repo to market, cost of printing new notes, etc), it had kept overall collections under PSU dividends largely unchanged from last year. This shortfall, along with some concerns with respect to telecom receipts this year, can potentially open up fiscal risks of 0.2 – 0.3% of GDP. Whether or not the government chooses to slip on fiscal deficit targets will probably only be known towards the end of the financial year. Our bias is to believe it won’t since such a slippage will constitute admitting to a macro-economic indiscipline; something the government has steadily avoided thus far. Even if it does, in the overall context of things a 0.2% slippage on account of capital receipt shortfalls will not be taken much adversely either by the markets or by the RBI. However, the larger point is this: Taking forward the point about incremental growth drivers, it is clear that government spending as a growth driver will have to largely take a back seat from here on.  Government spending is running ahead of last year’s run-rate already, with the result that the centre has already chalked up 81% of its annual fiscal deficit target by June end. This is by design as the budget was brought forward starting this year precisely so that some spending happens before monsoons start and bring all project activity to a stall. However, this also means that the government will have to belt-tighten in the months ahead, especially now with elements of capital receipts disappointing.

 

Exports have been another growth driver that had started to rebound at the beginning of the year. However, as is seen in the graph below, they have also started de-accelerating over the past few months.  Hence, both government spending and exports can no longer be relied upon as the same magnitude of incremental growth drivers in the time ahead, as they have been over the past few months.

 
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4. Latest CPI release: There has been some concern expressed with respect to the latest CPI print overshooting ‘consensus’ by around 30 bps. To be frank, our only concern here is with the quality of data that the average forecaster has used in predicting this reading. It may be recalled that vegetable prices had shot up over the month and basis data from ministry of consumer affairs we were expecting anywhere between 20 – 25% monthly pass through into the vegetable index of CPI. Hence, the data is broadly in line with our estimate and in fact has left us mildly relieved since HRA pass through has yet been quite modest so far. Core index has gone up largely presumably on account of GST related price hikes, whereas CPI – ex pulses and vegetables has actually continued falling. These are illustrated in the chart below.
Source: CEIC data and IDFC MF Research

 
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Conclusion

 

Our framework for fixed income, as discussed in a recent post policy note (please refer ‘In the Real World : A Post Policy Analysis, dated 3rd August 2017), is basically this: Now that there is relative comfort on ‘close to 4%’ on CPI getting achieved, the debate will sooner or later shift towards the appropriate real rate setting. A dominant factor here will be prospects of global financial volatility. If this were to escalate on the back of non-temporary factors (for instance G3 inflation returning), then the RBI may be happy to run with higher real rates. However, if the global backdrop continues to be sanguine then the state of the local economy may argue for lower real rates that is currently the case. Now if CPI remains well-anchored (as seems the expectation now) then this would entail further cuts in the nominal policy rates. For this reason, we have argued that it is as yet too early to call the end of the current cycle. Indeed, this is what the CEA seems to have concluded as well. Recent developments discussed here have done little to change this framework. Indeed, while escalation of geo-political tensions is always a risk, we now have a fuller analysis of the state of the local economy, courtesy a government document. This reaffirms the view that the private sector is in a weak state with no apparent near term growth drivers ahead. Till this state of affairs changes, monetary policy will always be in play given a well anchored future CPI expectation.

 

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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Arvind Subramanian & Khushboo Sharma

A Zebra with no Stripes

By: Punam Sharma

The credit fund industry has witnessed phenomenal growth, as can be seen from 45% growth (CAGR) over last 5 years taking their cumulative AUM to over 1 lakh crore. This growth has, however, been accompanied by an expectation that there won’t be any NPAs in the credit funds. In the past, any adverse credit events faced by the industry have been downplayed as “accidents” or “one-offs”. To refute this fallacy, we compare and contrast the credit fund industry with the banking sector. The following graph compares the cumulative size of the credit fund industry alongside the size of corporate loan books of some of the largest private sector banks.
 

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Put another way, if the credit fund industry were to be considered as a bank, it would be the fourth largest private bank in terms of asset size. Here, we only consider the corporate loan book for the banks since the credit fund industry is itself predominantly invested in corporate bonds. Since all banks don’t disclose asset quality parameters separately for corporate loan book, we have taken gross NPA as % of total advances as a proxy. In our view, the corporate loan book has a larger representation in banks’ NPA.
 

Can credit funds be any different?

As can be seen from the graph above, some of the largest, well-run private sector banks also have NPAs on their asset book. We seldom hear banks referring to NPAs as “accidents” since NPA formation are a routine phenomenon and are part of the business of taking credit risk. Keep in mind, our above analysis does not even consider other stressed assets held by banks such as restructured loans, SDR, 5:25 etc. Therefore, the question arises whether it is sustainable for credit funds to continue growing with nil NPAs, while a certain level of credit costs (losses owing to NPAs) is considered to be routine business by banks. At such a large scale, the credit funds may no longer be immune to risk of NPAs and isolated incidents can no longer be referred to as “one offs”. Moreover, the sheer scale and pace of incremental flows in credit funds has left lesser room for cherry-picking of assets.
 
The inevitable risk of NPAs in the credit fund industry, thus, calls for incorporating the possible impact cost of credit events in the selection of credit funds. The impact cost of such events can manifest itself in a fund’s return in two ways – the first being the valuation impact on the bond that has been downgraded by multiple notches and secondly, the investor panic that may cause a run for liquidity, thereby forcing fire sale of the unaffected securities. Both the abovementioned factors can contribute to a sharp drop in NAV, thereby creating a vicious circle of falling NAVs and redemptions.
 

Conclusion

Having established the parallels of credit fund industry with banks, we would like to point out, in our view,two major fallacies in the perception with respect to credit funds.
 

a) Size of credit teams being a sufficient condition for ensuring zero NPAs in credit funds

 
Despite the large and experienced credit teams, the largest banks have not been able to avoid credit costs. While large credit teams may be able to skew the probability of default towards a favourable outcome, large team size is not a sufficient criterion to ensure zero credit costs in the credit funds with the increasing size and complexity of the investable universe. Therefore, a certain level of credit costs should be assumed in the expected return of credit funds. However, the magnitude of credit costs will vary across funds and can be estimated from the investment philosophy and credit quality of the underlying portfolio.
 
b) YTM – a proxy for returns in case of credit funds

 

As we have seen in the banking sector, different banks exhibit different levels of asset quality which could be a function of various factors such as underwriting strength, risk appetite etc. Similarly, credit costs will not be evenly distributed across the credit fund industry and investor level selection of funds attains added significance. The weaker the credit quality of a portfolio (consequently higher YTMs), higher is the chance of credit costs adversely impacting its returns, thereby busting the myth of YTM being a proxy of expected return.
 

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

Introduction
 
From a market’s perspective, the August policy was probably the best possible outcome. This is because it causes very little disruption to respective underlying frameworks of individual market participants. There is enough here for both the ‘one and done’ as well as the ‘lower for longer’ camps. Ultimately, it remains the case that both the market and RBI are struggling with the same set of analytical questions. What is also the case is that neither has too much confidence in their predictive powers but both have begun to believe that inflation is likely to settle lower than initial thought even when some of the current sources of disinflation start to reverse.
 

The objective here is not to add another layer to the CPI analysis. Rather we start here on an assumption that the point where RBI and markets have common ground, that CPI is likely to settle lower and closer to the 4% mark once on-offs are removed, is largely correct. In that context we re-emphasize our underlying framework to analyze what the future monetary policy reaction function is likely to be.

 

One Thing At A Time
 
It may be remembered that the concept of RBI targeting, albeit loosely, some sort of a real rate was introduced in the Rajan era. However, the concept was changed around quite a bit before settling on the nominal anchor of 1 year treasury bill rate. Thus the real rate definition was presumably ‘1 year treasury bill minus forward expected average CPI’. We stick to this definition for current purposes.
 
In the October 16 policy, Dr. Patel and Patra had indicated that India can possibly do with a lower real rate target than the previously indicated 1.5 – 2%. This was subsequently abandoned in the December policy, presumably since the global context had changed by then with the arrival of the so-called ‘Trump trade’. It is to be noted that what is implicit in this change is also that RBI was comfortable targeting a CPI range in October and this moved broadly to a CPI ‘point’ in December. Of course, they said so as much when they explicitly introduced in December their intention to bring CPI closer to 4%. However, the conceptual point here is important: The debate on real rate is immaterial till the intended CPI target is broadly achieved. This is because the RBI cannot simultaneously target both a point in CPI as well as what spread over that to set on nominal rates. Thus if the achievement of its intended CPI target requires a higher real rate, then the RBI would have had to live with that.
 

Time To Get Real Again?

 

Thus the debate on real rate was only relevant up to October last year when RBI seemed content to target a CPI range rather than a point. Hence we haven’t found much merit in sporadic market discussion on real rate since that time. However, as confidence towards achievement of CPI targets gains ground, it is likely that a genuine debate on real rates re-surfaces. Dr. Acharya indicated in the August 17 policy that RBI is currently comfortable with real rates just outside of 1.75%. However, this has seemingly shifted the nominal rate used for real rate calculation back to the policy rate from 1 year treasury bill rate being used earlier.
 

Notwithstanding this, the larger point remains that once there is broad comfort of achieving the point target on CPI, the discussion on the appropriate real rate is likely to resurface. In our view, the dominant variable that will influence this discussion is prospect of global financial volatility. This view is basis RBI’s conduct between October and December 16. Thus when there was comfort with respect to the global macro backdrop, the RBI was happy to loosen its real rate target. This changed when global prospects became much more uncertain with significant rises in global bond yields and strengthening of the US dollar. It is to be noted that RBI was under the same management then as it is now, so one cannot assume a full about turn in their underlying framework.

 

Given this, the state of the world in the next few months is likely to have an important bearing on the real rate discussion. The current context on this is a persistent failure of inflation to reach central bank targets despite unemployment rates falling sharply and an almost complete dissipation of the Trump trade, at least in the near term. This has resulted in a significant fall in the dollar index, to levels lower than when the Trump trade started. Similarly the long end of the US yield curve has also given up much of the hardening that had happened post Trump’s election. Should this state of things continue, then it is highly likely that the RBI revises its current thinking on the appropriate levels of real rate.
 
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The graph above charts real rate differentials between US and India. We’ve used policy rates in both countries (not 1 year bills) and used core PCE (Personal Consumption Expenditures) and CPI (IW) respectively as inflation gauges for US and India. It is to be noted that the current differential is distorted and extremely flattering since India CPI is expected to rise from here. However, even assuming a 2% real rate for India places us closer to where the state of things were in the early part of the last decade. Thus there is adequate scope for the RBI to relook at the current real rate should the global backdrop continue to be benign. An added variable here is the significant concern that the RBI has expressed with respect to the state of private sector growth. While this doesn’t impact rate setting directly, it may eventually feed into thinking on the appropriate levels of real rate, ceteris paribus.
 
Conclusion
 
In our view, it is best to keep an open mind still on the current policy cycle, till the current benign global backdrop extends and / or generalized inflation doesn’t pick up locally. As on date, it appears that both these conditions are in place and so we are happy to retain a long duration bias to the market. Indeed if the period of weak local growth persists and core CPI remains sanguine while signs of late cycle weakness in US growth become more apparent, it is likely that market participants become more confident of further RBI easing. Conversely, if US (or G3 more generally) wage costs start picking up and / or signs of a coherent US fiscal policy re-emerge, then the rate cycle here may be over as well. Thus there is merit in being active on duration with a long bias right now. Shorter end rates will continue to look attractive with liquidity currently surplus and policy rates stable at worst..
 
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 delivered to the majority expectation in the policy; cutting repo rate by 25 bps to 6%. The stance has been retained as neutral as also widely expected. Market was really looking for the assessment contained in the policy for clues into future direction. Key aspects of the assessment, taken from both the policy statement as well as the post policy media interactions, are summarized below:

 

1. The confidence for the rate cut just implemented has come about owing to 1>A downward shift in assessment of future CPI even from the last policy. The baseline path of headline CPI has fallen to a little over 4% by Q4. In fact the Governor mentioned that including central HRA also the assessment for Q4 is of CPI to be closer to 4%. 2> Core CPI has fallen significantly over the past 3 months. 3> GST roll out has been smooth and monsoons normal.

 

2. CPI is expected to rise from here. This is well known and should not come as fresh news. However, the MPC is still struggling to determine how much of the current disinflation will unwind ahead. Thus the policy states that ‘a conclusive segregation of transitory and structural factors driving the disinflation is still elusive’. There is a promise embedded though that ‘the MPC will continue monitoring movements in inflation to ascertain if recent soft readings are transient or if a more durable disinflation is underway’.
 
3. Upside risks to CPI, as per the MPC, arise from farm loan waver led spillovers, states’ implementation of pay commission (which is not yet factored into the base line projections), and the building price pressures in vegetables and animal proteins.
 
4. There are decided concerns with respect to private sector growth. However factors affecting these and the resolution therein are largely perceived to be outside the immediate realm of monetary policy. Thus the MPC feels an urgent need to reinvigorate private investments, remove infrastructure bottlenecks, provide major thrust to the affordable housing scheme. This needs speedier clearances from states and resolution of stressed corporate balance sheets and bank recapitalization.
 

5. On liquidity Deputy Governor Viral Acharya indicated that RBI has been waiting for signs of currency in circulation to stabilize which seems to be happening now. The RBI will continue using all tools at disposal but with a view to not destabilize markets (reference to use of OMOs). While absorbing liquidity, the RBI will have an eye out for the medium term requirements of currency demand given the growth projections for the economy.

 

Takeaways

 

The policy provides little further updates to the framework that the market may already have been operating with. Both the RBI and markets have been somewhat surprised by the extent of fall in CPI and both are struggling to figure out how much of this is likely to be structural. To its credit the MPC has an open mind and seems willing to act further if parts of the current disinflation prove to be structural. It is to be noted here that the fact that inflation is going to rise from here is obvious to all. The question only is how much does it rise to once the dust settles on the current temporary factors at play. And on this, the RBI’s verdict seems to be that it will settle lower than where it earlier thought it would; and probably not very much higher than its 4% target. The other fact is that the MPC is quite worried about private sector growth. While this may not directly entail a reaction from that, it is reasonably clear that they will not look for the closing of output gaps in the near foreseeable future. There is a chance that the RBI steps up its liquidity operations as currency in circulation trends stabilize. Here, the chatter underway that MSS ceiling may get hiked may prove useful and may eliminate the need to step up OMOs.
Ultimately, and as the turn to policy between October and December suggested, the so-called real rate to be maintained will also ultimately depend on what the global backdrop is like. It is to be noted that the debate on real rates only assumes significance once there is broad comfort on achievement on CPI targets. Thus if the current benign global backdrop persists then the MPC may have no choice but to eventually lower the real rate target or else sustain continued pain from an appreciating currency.
Given these, bonds remain very much in play for asset allocators. A decisive turn to the cycle will have to be accompanied by either a turn in local CPI and / or an escalation in prospects of global volatility. The market is none the wiser on these prospects post 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.

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