By: Punam Sharma
As the recent Turkey episode has served to remind again the global backdrop remains quite volatile, thereby making it difficult to execute any kind of portfolio strategy in the short term. This is reflected very much in investor behavior where preference is either for cash assets (liquid funds) or for exactly defined asset liability (fixed maturity plans). The problem, of course, is that there is little in the world that suggests that uncertainty will disappear suddenly at some foreseeable future with the magic stroke of an invisible brush.
Given this, one can try and stay with a ‘big picture’ view or framework and have portfolio constructs around this. This helps arrange an order to things so that risks can be considered as acceptable or not. This note details our big picture view to whatever extent we have been able to formulate it and the associated portfolio strategies that we are most comfortable with. Considering that the context is fixed income, the relevance of the framework is over months and not years.
1. Growth: Our core thesis on growth is that the best is largely behind us. The world experienced a phase of synchronized recovery between early 2016 – 2017 which India didn’t fully participate in owing to domestic reasons. This phase is now past us as significant growth variations have started cropping up among the major world economies. This is shown in the graph below
Thus while EU and Japan have started to slow starting 2018, the US continues with its momentum, aided by fiscal stimulus now in place. This state of affairs is robbing the world of an automatic ‘pressure valve’ that should have otherwise kicked in; that of dollar weakness. Unlike previous episodes of global growth weakening, this time the bar for the Fed to alter course is that much higher given the domestic momentum that their economy is experiencing.
The slowdown in Chinese data is particularly noteworthy. This is owing to the lagged impact of deleveraging and associated crackdown on the so-called shadow banking system as well, and not just from tariff threats. The chart below shows the slowdown in total financing availability and how fixed asset investment growth has touched a multi-year low. Indeed, policy is now pulling back in China both at the central bank as well as at the government level. However, the leeway to do too much is lesser now given the accumulated leverage in the system and the fact that the stronger US economy is creating a hostile global backdrop. Also, incremental measures may take time to turn momentum around for the economy.
India’s real economy link to the world via trade growth is now increasingly coming under pressure with export growth turning lower. However, as the chart below shows, a slowdown in exports is a global phenomenon associated with the break down in the synchronized growth narrative.
Source: CEIC. Note: Countries included are Indonesia, Malaysia, Philippines, Thailand, India, China, Vietnam, Hong Kong and Taiwan
The first impact of the export growth slowdown for India has been a significant widening of the trade account. Since our recovery is more recent and because there may have been some temporary local supply chain disruptions owing to demonetization and then Goods and Services Tax (GST), imports have been much more resilient thus far. And of course, oil has played a part as well.
Thus it is very improbable that India’s growth recovery remains intact in the face of a much more hostile global macro. While an anticipated rebound in rural income may help, the squeeze on disposable incomes from higher oil prices and some of the tailwinds from pay commission likely dissipating in the future may neutralize some of the effect. However, given the recent momentum one shouldn’t expect an abrupt slowdown in concurrent indicators. Rather, one should watch for sequential fall in momentum over the next two quarters.
To recap then, the recent momentum in India’s growth should be looked at as payback to some extent for the earlier slowdown which was largely owing to domestic reasons. Unfortunately for us, however, the period of synchronized global recovery is now past and will tell on local prospects as well through the trade and financing channels; in our view. This is a key reason why we believe that the current rate hike cycle will be shallow despite a over 100 bps rise in average CPI from last year, and to levels much beyond the 4% target. To be clear, given the global backdrop, we don’t believe the RBI/MPC will have luxury to respond to growth concerns. However, if the current confidence with respect to growth and capacity utilization were to abate, the RBI / MPC may then be more patient to let the slower growth momentum work its way into inflation. Thus we expect a shallow rate hike cycle, with one more hike pending in our current forecast.
2. Inflation: From a cycle low average of 3.6% for FY 18, CPI average is slated to rise by more than 100 bps this year. It is well known that last year’s average was unsustainable and to that extent some uptick this year would not have been too worrisome. The bigger issue is around the considerable forecasting uncertainties that have crept up now which is leading to reasonable dispersions of views. It must be noted here that the RBI’s own forecasts aren’t particularly alarming, should they come out to be true. Thus the central bank expects CPI to be at 4.6% in Q2, 4.8% in H2, and 5% in Q1 FY 20. There are a few interesting observations to be made here: First, RBI’s Q2 forecast is likely to be undershot by a significant margin. Thus July was 4.17% and August is likely to print below 4%. This leaves September doing a lot of heavy lifting if 4.6% is to be achieved. This also implies, alongside commentary from MPC minutes, that the bar for an October rate hike is extremely high. Second, RBI’s H2 forecast incorporates the revised MSP impact. This has been explicitly mentioned in the MPC minutes. Also, the risks to the forecasts have been termed evenly balanced. With this forecast, the RBI is actually lower than many private sector forecasts (including our own). The larger uncertainty this year is emerging from two counts: The first is owing to the fact that vegetable prices have been remarkably muted this year as shown in the graph below.
As can be seen, the average month on month rise in vegetable prices has been almost half of last year so far, and more in line with FY 16. Moreover, prices typically fall over the rest of the year. The other source of uncertainty is from the implementation of MSP. Thus while on paper impact is of the order of 90 – 100 bps, it is well understood that the actual impact may turn out to be far lesser and will depend upon both the method as well as effectiveness of ultimate procurement. All told then, the maximum uncertainty over CPI will likely be over Jan – March 2019 and the likely trajectory there should decide whether further policy action is needed.
There has been commentary lately as to how MPC will have to hike when RBI has a 5% forecast for Q1 FY 20. We think it is perfectly logical not to, since there is no reason to assign extra weight to a particular quarter’s CPI print. If averages for FY 20 move up further over FY 19 then of course it would be another story. Another argument heard is that rate hikes have to be stronger as the MPC nears the end of its first tenor and CPI still doesn’t move to 4%. Again, we find little merit in this line of thought. Developed market central banks, who have CPI variables that are much more impacted by monetary policy than ours, have still been missing CPI targets for years. Their credibility seems to have largely survived these misses. So will ours so long as the RBI / MPC continues to act responsibly and directionally is consistent with the anticipated trajectory of CPI.
3. Liquidity: Seasonal observations of currency in circulation (CIC) trends got disrupted with the ‘de’ and then ‘re’ monetization of the economy. The best way for us is to map current trends with 2016 (for first half of the year ) and 2015 – 16 (for second half). Basis this, it appears that currency in circulation trends are now largely stable at around 11 – 12% growth over 2016. Taking this forward, October – March rise in CIC is comfortably expected to be INR 2,00,000 crores or more. Even assuming no additional forex outflow from spot reserves (which is quite unlikely) and accounting for the fact that the RBI will let liquidity slip into deficit mode in H2, one is still left with an OMO figure which is well in excess of INR 1,00,000 crores between October – March.
In hindsight, the INR 90,000 crores of OMO sales last year while the economy was still in the midst of re monetization was avoidable. Hence, the current OMO requirement has to be seen in context of unwinding that measure and then move to address a substantial swing in balance of payment flows as well as currency in circulation trends.
Putting all of the above together, the view remains one of a shallow rate hike cycle. The prudent up-fronting of hikes thus far has created some space to let things be, especially as near CPI prints are under-shooting expected trajectory. If our view is correct, there will be adequate signs of sequential slowdown in growth momentum by Q4 of FY19. This should allow the RBI / MPC to settle for a final rate hike at worst around that time, even given minor temporary overshoots in CPI during that period.
Term spreads have already adjusted well, especially for sovereign bonds in the 5 year segment. If our view on OMOs and a final rate hike pending holds, then the current level of 5 year government bond yields are providing more than adequate comfort for taking long positions. Also, market positioning is now much better than a few months back, courtesy the INR 30,000 crores of OMO purchases already done, FPI selling abating, and stronger action from banks. This has had the effect of narrowing trading ranges and reducing market volatility thereby allowing the running of passive positions.
The sequence of value in such a situation runs from government bonds, to AAA, to lower rated. Corporate bond spreads will likely widen even on AAA bonds. However, this may end up happening bullishly as government bond yields fall as net supply adjusted for OMOs falls over second half; whereas corporate bond yields remain stickier on account of higher back-ended supply both on corporate bonds as well as SDLs. However, the outcome is unlikely to be as sanguine for lower rated bonds. These are set to unwind the spread narrowing that they have benefited from over the past year. Indeed, this is happening already globally for credit. However Indian credits have so far been largely shielded, predominantly owing to lack of liquidity and adequate price discovery rather than for any benign macro reason. Given this, the historic ‘lazy’ approach to filtering funds on yield to maturity should now be shelved. Instead focus needs to decisively move towards quality and liquidity. The macro backdrop is ripe for spread widening amidst rising refinancing risks.
The one risk to the framework and view here is from further large disruptions to emerging market risk pricing, most likely from a further appreciable rise in the US dollar. If this were to happen, the RBI / MPC may have to abandon all other considerations and just focus on preserving macro stability. In this case the view both on shallow hikes as well as on liquidity injections may have to be modified. However, this is a risk that will be ever-present in the current global context till the time that US economic data starts showing a noticeable deterioration. There are a few points that need to be remembered in this context: One, unlike in 2013, real yields are already very well adjusted today (almost 3% at 5 year point) while the overall macro situation is much better. Two, if one is still playing the widening current account theme in the context of larger global uncertainties, then one is essentially off risk generally; save for tactical trading. Thus it will be hard to argue that 3% real yields don’t cut it, but 3.25% do. Three, should further large global volatility come about then the order of performance will be : cash, government bonds, AAA, lower rated credit. However, in this case some of the lower rated issuers which aren’t robust businesses themselves or backed by robust promoters, may actually be facing existential risks. Thus what is almost amusing today is an analysis that takes into account all the local and global risks but then concludes that a high carry ‘accrual’ strategy (read high yield credit) is the best.
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