Suyash Choudhary

Introduction

 

The most important factor in the bond market today is to be able to ascertain whether or how soon the RBI is likely to start hiking interest rates. With every incremental rise in bond yields, the discussion has turned more hectic with the thinking being that the bond market is the early indicator that is already signaling rate hikes. To be sure the recent fiscal stress and a sharp up move in oil and other commodities, alongside already hawkish RBI commentary, is bound to trigger some sort of rate change expectation. The issue, however, is whether the market at current level is overly fearful of future potential RBI action.

 

Overpricing Rate Hikes?

 

As an example, the 4 year government bond is trading almost 125 bps over the repo rate. As a simplistic exercise suppose the choice is between holding this bond till maturity or running cash that will be deployed at repo rate for the same period. Even if the RBI hikes rates by 200 bps 2 years from now, the holder of the bond will still end up making at least the average repo rate over the 4 year period. If the rate hikes happen sooner, obviously the quantum of rate hikes that can be absorbed will be lower as well. However, even then the protection built in is significant. Thus, a more than 125 bps hike at the end of 1 year can be absorbed and the trade will still return better than average repo rate over the 4 year period. To view this from another perspective, the average spread between the 4 year government bond and the repo rate for the past 5 years has been 57 bps as per Bloomberg data, against the current spread of 125 bps.Thus if much of the most recent sell –off in bonds, particularly since early December, reflects largely an absence of market risk appetite rather than a conscious re-pricing of RBI’s rate hiking path, then there is a real opportunity for the current year; especially in front end bonds where such re-pricing seems most obvious.

 

Even with an inflation targeting mandate, the state of the economic cycle is a key input into the decision making process for the RBI. If the growth backdrop is still relatively weak with consequent output gap implications then the central bank can have more patience with rates. Indeed, this seems to be the thinking from the last monetary policy statement as well. While there has been some pick-up in economic activity indicators over the last few months, it is important to understand that the rebound is happening from a position of extreme weakness when compared with recent history.  The recently released advance estimate for annual growth by the CSO (Central Statistics Office) seemed to indicate as much. Thus the CSO has pegged full year GVA growth at 6.1% versus the RBI’s estimate of 6.7%. While it is likely that the CSO is a tad conservative and that the growth figure may be revised upwards later, it is apparent that the economic rebound we are currently witnessing is from a very low base.  This then still doesn’t look like an economy that can absorb the kind of rate hikes that the bond market already seems to be pricing in.

 

Some Relevant Charts Around The State of Growth
 

We present below a series of charts which further demonstrate this point.
 

Source for all charts barring the one on PMI is CEIC. Source of PMI chart is Bloomberg.

 
graph1_2617

 

The chart above summarizes the extent of India’s growth slowdown. As can be seen, real GVA has slowed sharply since early 2016, a trend that only seems to be now reversing over the past few months. It is important to realize that the slowdown had set in before demonetization although demonetization and GST may have, at least temporarily, accentuated the slowdown.

 
graph1_2617

 

A similar trend emerges from the next chart that tracks non food credit growth. While some revival is evident in recent data, the growth rates are still the lowest in the last several years. Admittedly, part of this is owing to disintermediation as well as diversification to offshore sources of funds. Nevertheless, bank credit growth still remains weak and needs a substantial investment cycle ahead to meaningfully pick up.

 

graph1_2617

 

A further breakdown of credit shows industrial credit continues to be remarkably weak. Given that it constitutes the largest chunk of outstanding bank credit, any substantial and durable aggregate credit pick up will require industrial credit to start recovering as well.

 
graph1_2617

 

The chart above does point to early green-shoots for an investment recovery. Thus RBI surveys suggest some pick up in new orders. However, again the trend is early and mixed at best. Thus CMIE data (not graphed here) paints a grim picture at least till Q3 FY 18 with stock of stalled projects at all time highs and new project announcements falling sharply. This is amply demonstrated in the chart below via a different set of data. Thus while there was some revival in forward business expectations, current expectations were still subdued in the September 17 quarter.

 

graph1_2617

 

Also capacity utilization remains sub-par as per the chart below, another sign that meaningful industrial credit recovery is still some time away.

 
graph1_2617

 

The next chart signals more bullishness with respect to the recovery currently underway. This pertains to auto sector sales growth.

 
graph1_2617

 

PMIs have rebounded as well as shown below. However, there is still discrepancy between the sharp rebound in manufacturing PMI and the more gradual turn in services PMI.

 
graph1_2617

 

Finally, while retail loans are booming, anecdotal evidence suggests that job gains are much weaker. Also, consumer confidence is yet to revive meaningfully as the chart below suggests.

 
graph1_2617

 

Conclusion

 
There is no doubt that incremental fiscal stress and the recent sharp rise in oil prices have deteriorated India’s macro-mix on the margin. Alongside there has been some pick-up in growth over the past few months, which has made observers even more wary with respect to RBI’s future reaction function. The intent here is to show that even though a variety of growth indicators have improved, they are coming off a very low base. At an aggregate level the picture is of an economy that is now recovering from a recent slowdown that was largely unique to it, even as the rest of the world was already accelerating. To us this doesn’t look like a backdrop where the RBI can contemplate any meaningful reversal to its current stance. This is especially true since the best sign of macro-stability, the currency, is firmly well behaved still. A proactive government is further contributing to the perceived macro-stability. In this context, it is difficult to be too harsh about the minor fiscal slippage that is likely this year given that it comes not from any sort of an irresponsible expenditure enhancement, but is rather owing to the revenue after-shock of a well intended macro reform.

 

Given this context, it is likely that the bond market is overpricing the extent of near term rate hikes from the RBI. The opportunity is clearest in front end rates (2 – 7 years) where the element of excess rate hike fears seems the most apparent. Our base case remains that of a prolonged pause from RBI. However, even if a symbolic hike were to come about sometime later in the year, rates at the front end are more than compensating investors for it. The main risk to this view is largely external: from any sort of a disruptive rise in the US dollar.

 

Disclaimer:
 

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