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Investment Insights

Suyash Choudhary

Introduction

 

To recap, over the past few months we have aligned our thinking on fixed income around a ‘real rate’ framework. The thesis has been that now CPI targets have been broadly achieved for a long period, the discussion should shift towards the appropriate real rate setting. To us, this decision should have been based on two factors: One, the state of the local economic cycle. Two, prospects of global financial volatility. Both these have conclusively argued for a lower real rate setting, in our view. Thus local growth has slowed over the past year and half just as the rest of the world has accelerated. And the stable global dynamics versus India’s real rate stance is amply visible in the massive accumulation of spot and forward reserves that the RBI has done since the start of this year. However, the RBI and the monetary policy committee (MPC) don’t seem to be operating off any consistent framework on real rates as the policy just gone by has amply demonstrated. Furthermore, the narrative around CPI also remains relatively tentative despite their forward projections ex- of central HRA largely hugging the target. Nevertheless, and whatever the reasons, we have misread the RBI and MPC over the past few months.

 

New Developments

 

There are three new developments that merit attention. These are briefly discussed below:

 
1. G3: There are incremental developments in the G3 block that merit attention. In the US, the passing of the Budget resolution has raised optimism with respect to the tax plan seeing the light of day soon. Simultaneously, the decision on the next Fed chair seems imminent with some expectation that the new appointee may have a hawkish leaning. In Europe, the European Central Bank (ECB) is close to announcing some exit schedule on its quantitative easing (QE) program. Whereas, Japan is leaning the other way with Abe’s recent election victory paving the way for continued aggressive easy money policy from the Bank of Japan (BoJ). Amongst these, in our view, the US tax plan seems the most significant risk that can cause significant dollar strength to re-emerge with corresponding less attraction for emerging markets (EMs), including India. A more hawkish Fed chair by itself in absence of a tax plan and / or a credible rise in inflation, should only succeed in further flattening the US yield curve with potential consequences for real economic growth down the line. Whereas, the ECB taper may be long drawn and the BoJ aggression may partly counter-balance the winding down from the other 2 large central banks
 
2. MPC minutes: The minutes of the October policy were released recently. To us, there are no surprises there as far as the three RBI members  and one external member (Dholakia) are concerned. However, the other two external members were more hawkish than what we would have expected. On balance then, the minutes indicated an even higher bar for further rate cuts.
 
3. Government’s growth push: The most recent development is the mega announcement by the government around public sector bank (PSB) recapitalization and stepped up spending over road networking. The government has announced a INR 2.11 lakh crore PSB recapitalization plan which comfortably engulfs even optimistic expectations with respect to any such exercise. Of this, INR 1.35 lakh crores is expected via recapitalization bonds. The modalities of these bonds are yet to be decided, barring an expectation that they are likely to be front-loaded. Presumably, they will be issued by the government or by some agency floated by the government. They may be directly placed with banks and the funds thus raised may be given back to the respective bank as equity capital. The following implications seem noteworthy:
 
a. We wouldn’t yet worry about  the bond supply implication for this program. While in theory the recipient banks may sell these bonds to the market or be less inclined to buy new bonds in their investment books, it is equally likely that these bonds come under some lock-in or are part of a special carved out held to maturity (HTM) limits.
 
b. There is little implication here for headline fiscal deficit. These bonds are ‘below the line’ and only the interest cost associated with these will hit the fiscal. Also, the government may further ‘distance’ itself fiscally by bringing in a quasi government agency to issue the bonds. However, this may disappoint purists especially as we keep capital receipts like disinvestment proceeds ‘above the line’ it may be argued that the same treatment should be followed here. However, from a practicality standpoint  and for bond market implications, this doesn’t add to government headline deficit.
 
c. However, this does potentially further raise the bar for the next RBI rate cut. This is because the government has now moved aggressively to address the problem of the credit multiplier. This creates further inertia for the RBI to act on growth, especially given the MPC’s new concerns on inflation in the context of rising global uncertainties. Thus even a weak September quarter growth print may sway the MPC lesser, now that they know that the government has strongly moved to address the credit multiplier. Rather, the RBI may be content for now to pursue with more gusto their ongoing project of ensuring more transmission into bank lending rates.
 

Implications and Portfolio Strategy

 

In order to clarify one’s thinking, one should park expectation of further rate action for now and then look for opportunities on the bond curve. Aided by RBI’s bond sales, rates even  in the 5 – 10 year sector have also risen to between 80 – 120 bps over the repo rate. They are steadily approaching (if not already in) a zone where they will look reasonably attractive even without expectations of a rate cut. It should also be noted that if rates were to rise another 25 bps, there will be parts of the market rate curve that may start to deal at or higher than banks’ MCLR rates. The point here is that the structure of interest rates in the country, with CPI between 4  and 5% and corporate loan demand still likely to be subdued, itself doesn’t allow for much higher rates from here. Finally, some of the scare around fiscal deficit slippage has been addressed lately as well by the finance minister. Thus it looks like the government will adhere to the ‘glide-path’ of progressively reducing deficit even if there is some expansion from the budgeted levels. This means that the deficit should be within 3.5% this year and lower the next. With some adjustments to the voluntary bond buy-back program meant to smoothen future maturities, this may not entail any meaningful additional supply of government bonds in the last quarter of the current financial year.

 

On our part, we have steadily run between 15 – 20% cash in our active bond and gilt funds since the October policy. We have also moved almost an equivalent amount of bonds from the 12 – 13 year maturity bucket to the 6 year bucket. In line with what has been explained above, the intent is to focus on absolute value in an environment of minimal future rate cut expectations. We may look to add tactical ‘beta’ in the future should the framework undergo some change basis incoming information.

 

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

Policy days refuse to end these days given that the incremental ‘information’ keeps coming over RBI interactions well into the evening. Thus, apart from a media call in the afternoon, there is a conference call with analysts in the evening as well. The value of these calls is that the RBI team answers questions which allow for a somewhat deeper understanding of how they are thinking about various aspects of policy. Whereas, the written policy document itself may not provide this amount of color. The flipside is that there are some off-the-cuff remarks as well during these calls which, given the tendency to latch on to every word uttered by the central banker, the market may tend to take at full face value. With these caveats in place, we summarize below our key takeaways from all documents, calls etc that we read / heard yesterday:

 
1. The market is still struggling with a consistent narrative as far as RBI’s thinking on real rates is concerned. More specifically, the confusion here is not only on what real rates RBI wants but something rather more fundamental: how in RBI’s view is real rate calculated. Over the Rajan era, after some iterations, this had settled at ‘1 year treasury bill rate minus CPI’, with the working hypothesis being that CPI here should refer to some sort of averages given that RBI cannot surely keep targeting just one reading on CPI. However, the concept seems to be undergoing some modification again. Specifically, there are 3 confusions here: One, whether one has to look at CPI averages or just year closing point. Two, whether one has to strip out the effect of HRA or not (logic dictates that one should, given that the effect is largely optical). Three, whether the reference market rate is RBI policy rate or 1 year Treasury bill. Only once these are solved can one then move on to the critical question of what real rates RBI is comfortable with given the state of the economy and the assessment of global financial volatility. Pending clarity on these, the best anchor the market has is to just look at CPI overshoots / undershoots versus RBI’s stated trajectory when assessing probabilities of future monetary easing.
 
2. It was known even before that some of the current ‘uncertainties’ around CPI were certain to come. These largely have to do with the HRA component of pay commission and some upward revision to prices post GST. However, when these are actually at our door, the default position is to view them from a position of suspicion. One may argue that this is indeed the prudent position for an inflation targeting central bank, especially because the exercise in such targeting is still in its infancy. However, the counterpoint is that this ends up making market participants believe that we have may have an inflation problem, when we really don’t. To be clear about the context, the RBI’s own forecasts suggest that CPI will be within 60 – 90 bps of its 4% target (which, it must be remembered, is the mid-point of the range) over the next 1.5 years, even accounting for the optical effect of the central HRA. Not only is this effect to be looked through, but this also means that stripping out the HRA effect the RBI is actually forecasting CPI to be almost exactly at its target (and at mid-point of range) over its forecast horizon. This, after, CPI already having spent almost a year now at sub-4% levels. To reiterate, then, India doesn’t have an inflation problem and hence if there ever was a time to sound confident (which is distinct from sounding complacent) about our macro-stability it would be now. However, if via RBI’s commentary, the market starts to believe that we may have a problem then it will unnecessarily start adding term premiums for buying bonds thereby counter-acting the transmission of RBI’s own previous easing.
 
3. The Monetary Policy Report analyzes in detail the effect of the excess liquidity created in the banking system post demonetisation on inflation. It assess that ‘inflationary pressure could have emerged only if, illustratively, banks had leveraged on easing liquidity to expand credit at a rate faster than the growth in nominal GDP, leading to higher demand for money and stronger growth in broad money’. This clearly did not happen and the report goes so far as to observe that ‘a similar dynamic appears to be playing out under quantitative easing’ and that ‘advanced economies, in fact, experienced deflation risks despite large surpluses of liquidity sloshing around’.  Hence it concludes that ‘it is, therefore, not surprising that post-demonetisation surplus liquidity has not had any impact on inflation in India so far’. It is curious thus that despite this analysis at hand, the RBI persists with OMO sale of bonds but at the same time be apparently worried about the potential crowding out from general government fiscal slippages. One assumes here that there is no distinction between the effect on inflation of liquidity created via demonetisation and that through RBI’s forex purchases even though the tools detailed to absorb them may be different.
 

Conclusions

 

It is apparent that market uncertainty has been enhanced post policy for the near term. This may cause some amount of ‘supply discount’ being built into yields when participants absorb bond supply over the next few weeks. Respecting this, we have tactically reduced maturities in our bond and gilt funds and created some cash. It is important to emphasize, however, that this is purely tactical as we wait to see how the auction supply gets absorbed over the next few weeks. The underlying framework remains intact and we still think the RBI may be over-estimating both the evolution of CPI as well as the potential economic rebound down the line. Given the room it has flagged around potential increase in output gap, this would mean that the current rate cycle is very much still in play. The same conclusion can be had from the central bank’s genuine worry about the state of private sector investments, although as of date it only ascribes non-monetary remedies to this problem. There is no implication here for investors so long as the medium term construct is intact.

 

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 kept all rates on hold as was largely expected by the market. However, there was some hope for incremental dovishness in tone and to that extent there is near term disappointment. The key takeaways, in our view, were as follows:
 
1. RBI has marginally hiked its H2 FY 18 inflation forecast from 3.5 – 4.5% mentioned in the last policy to 4.2 – 4.6% in the current one. This forecast includes impact of central HRA. Thus while the top end of the band is largely unchanged, the bottom end has been brought up. Over FY19, CPI is expected to peak at 4.9% in Q3 before softening to 4.5% by Q4. This assumes a normal monsoon next year and no exogenous shocks and includes the effect of central HRA. Upside risks to CPI include impact of state farm loan waivers and implementation of state HRA. The latter can impart a statistical 100 bps impact over the base line over the next 18 – 24 months which may have second round effects. On the other hand, adequate food stocks and effective supply management by the government may keep food inflation more benign than assumed in the base line forecast.
 
2. The central bank recognizes the loss of momentum to growth in Q1 FY18 which, alongside somewhat weaker kharif production and impact from GST, has imparted downside to the growth outlook. Real GVA forecast has been accordingly reduced to 6.7% from 7.3% earlier. The RBI seems reasonably optimistic on growth picking up in the quarters ahead owing to GST effects fading and anticipating a household consumption boost from implementation of pay commission by states. On the negative side, it quotes margin pressure on corporates and the weakened consumer confidence with respect to income, employment, income, prices faced and spending incurred.
 

Takeaways

 

There is concern expressed by the MPC around recent rise in CPI just as global uncertainties are picking up due to efforts at policy normalization in US and Europe. The added uncertainty from prospects of fiscal slippage is also something that the MPC has an eye out for. That said, there is  also acknowledgement of the likelihood of output gaps widening. However, the MPC needs more information before they can make that call and act on it. Meanwhile, the RBI has flagged the importance of factors outside of monetary policy to revive investment demand including PSU bank recapitalization.

 

It is quite likely that we see a repeat of the set up seen last over April – June; that the RBI ends up overestimating CPI trajectory over the next few months. This could have an added context if the anticipated rebound in economic activity doesn’t materialize to the extent envisaged. Given these, and the fact that even in this policy the RBI has clearly acknowledged risk of output gap further widening, we reiterate our view that the rate cycle is well and truly in play still. That said, it may take the next couple of CPI prints for confidence to build that RBI is indeed over-estimating the near CPI trajectory. This may lead to some additional supply discount being built for the auction schedule over the next month. However, whether or not this happens, the medium term construct remains bullish and this more than anything else is what should drive asset allocation behavior, in our view.

 

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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