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Investment Insights

Suyash Choudhary

Introduction

 

A lot has changed over the past few months. From a point in September where market was pricing in more than three back to back further rate hikes, the 1 year swap currently at 6.95% is now pricing in about one rate hike; and that too not immediately. To take another example, the 4 year government bond (our favorite trade for a long time) has rallied by more than 70 bps  from its recent peak. A lot of factors have helped in this dramatic move down in yields. First the RBI committed more aggressively to Open Market Operations (OMO) bond purchases since late September as core system liquidity deficit started to rise more appreciably. Two, in its October policy it effectively broke the market’s false causation that interest rate hikes are needed as a defense against the rupee weakness. Three, food inflation has simply refused to pick up thereby setting the stage for meaningful undershoots to even the most recent downwardly revised forecasts of the RBI. Four, oil prices have seen a dramatic drop, with Brent prices falling some 30% from its early October peak. This has also had a sanguine effect on the rupee.

 

A View Recap

 

Our ‘big picture’ view expressed in late August (please refer “Making Movies: “The Big Picture”, dated 21st August for details https://www.idfcmf.com/insights/making-movies-the-big-picture/) had two major components: One, that this rate cycle is likely to be shallow. Two, OMO purchases will be well in excess of INR 1,00,000 crores between October – March. The view of a shallow rate hike cycle was underpinned by an expectation that peak growth is past us and that 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. The view was that the period of synchronized global recovery is now past and will tell on local prospects as well through the trade and financing channels. The sequence of value we had preferred ran from government bonds, to AAA, to lower rated. We had cautioned that the macro backdrop is ripe for spread widening amidst rising refinancing risks.

 

Over the turbulent month of September, we had argued against an interest rate defense for the currency. Our view was that financial conditions had already tightened significantly and that  a rate hike via the Monetary Policy Committee (MPC) cannot be for currency considerations, but only if the weaker currency now leads to an assessment of higher (Consumer Price Index) CPI in the future (please refer “Back To Bedlam? A Bond & Macro Update, dated 6th September for details https://www.idfcmf.com/insights/back-to-bedlam-a-bond-macro-update/).  In fact as financial conditions continued tightening, helped by certain credit episodes, we thought that the RBI should move towards ensuring better policy predictability as a means to establishing some measure of financial stability. We had expressed a view that one should expect less and not more hawkish outcomes of policy relative to expectations (please refer “Too Tight? A Market Update, dated 24th September for details https://www.idfcmf.com/insights/too-tight-a-market-update/ ).

 

The Shifting Narrative

 

Courtesy the list of factors mentioned in the introduction above, the narrative has somewhat shifted for fixed income. Thus as is evident in the view recap above, the argument then largely was that the market was overly pessimistic with respect to its forward rate hike expectations. Hence, it made sense to be aggressively long the front end of the curve. The trade would also be helped by the under-pricing of OMOs at that juncture.

 

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However, one can now possibly lead with a more positive narrative. As noted before, the 1 year swap has retraced meaningfully and is currently pricing in just one rate hike. The graph above tracks the swap rate versus movement in the rupee. As can be seen, while both have moved in the same direction as is intuitively to be expected, the fall in swap predates the strengthening in the rupee tracking the RBI’s move to aggressively reestablish policy rates as a tool to manage inflation and not defend the currency. Alongside, the recent fall in oil prices is also tracking a demand narrative; just as was the case with the fall in other commodities earlier in the year. Growth around the world barring the US has been slowing for most of the year.

 

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The graphs above track the Citi Economic Surprise Index for major economies. As can be seen, data surprises have largely been negative for the past few months for major economic blocks including Euro Zone, Japan, China, and Emerging Markets. This kind of an external environment poses a strong headwind to growth for our own economy as well. This underscores our key view of peak growth being past us. The interesting economy to watch for obviously is the US. The hypothesis to test is this : A phase of synchronized recovery that lasted till 2017 turned into unsynchronized growth over 2018 as the US continued to grow responding to a late cycle fiscal stimulus whereas the rest of the world started to slow. Can the next phase now be of a synchronized slowdown as incremental US growth impulses start catching up with the rest of the world? For now one has to keep this as a live hypothesis and await further confirmation. Interestingly, key Fed commentary lately has taken note of the international growth slowdown, the prospects of fading fiscal stimulus and the lagged effect of tightening already done.

 

Where Do We Go From Here?

 

It is very likely that the current rate hike cycle is already over. Near term CPI prints will be sanguine with the average CPI for October – March currently tracking closer to 3.5 – 3.75% versus RBI’s most recent, downwardly revised forecast of 3.9 – 4.5%. There is a risk, however, for CPI to rise meaningfully from there especially given that the current composition seems quite untenable with food inflation running negative. Indeed, this is probably why many rate hike forecasts have been retained but pushed forward. Hence, it is also important to assess where we are in the global economic cycle. Our leaning, and basis indications so far, is towards a hypothesis that we are very late cycle with fading incremental growth impulses. Specific domestic triggers are adverse as well, including the possible impact on credit flow to certain sectors post the recent credit concerns. Thus if our hypothesis is correct, the current phase of lower CPI backed by low food prices will give way to a phase of slower growth which will take away the MPC’s current concerns with respect to a closed output gap. Hence, we expect that rate hikes have not been pushed forward but been eliminated altogether.

 

While RBI has stepped up liquidity provisioning, it is now a case of running to stand still. Thus even after INR 1,26,000 crores of OMO purchases done so far, our assessment is that core liquidity will still be deficit around INR 1,75,000 crores or more by year end. Thus there is still some heavy lifting to do on liquidity and we think the RBI will have to do another INR 75,000 crores at least of OMOs by year end. Some offset may be provided if dollar flows turn and RBI can intervene to build some reserves. This will be especially true if the US dollar were to indeed stabilize or turn direction and emerging market flows were to restart to some extent. From a bond perspective, however, this will create bond demand and to that extent market may not mind the somewhat lower OMOs. Finally, there is chatter of a CRR cut as well. We believe that the bar for this is quite high especially since the stance of monetary policy has recently been changed to ‘calibrated tightening’.

 

From a strategy standpoint, overweight quality front end (up to 5 year sovereign and AAA bonds) remains a very compulsive trade. As can be seen in the graph below, while yields have rallied somewhat, spread to overnight rate on 5 year AAA bonds is still close to recent historic highs. It is quite likely that this compresses going forward as market unwinds any residual rate hike expectations.

 

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The large barrier for longer maturities has been fiscal uncertainties. Indeed, as things stand, fiscal looks like the weakest leg of our macro currently. Balancing this, however, is the ongoing verbal commitment from senior government officials of no breach to targets. Also, in the one month since we last reassessed the long end, CPI impulses have faded further including with a massive correction in crude prices. Even though some bit of this correction may well prove to be excessive, it is quite likely that the range is now more stable and significantly lower than the highs touched in October. All told then, some selective exposure to the 10 year segment including via spread assets like corporate bonds and state loans may be in order in active managed bond and gilt funds.

 

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

Qu’AAA’lity, Qu’AA’lity or Qu’A’lity? – An Update on Credit Markets

 

The credit default/sharp downgrades faced by IL&FS & its group entities have had a knock-on effect on the credit markets in recent months, thereby resulting in heightened investor concerns regarding select issuers and sectors. This concern and fear among investors has manifested itself in the form of increased redemptions in the credit fund category, clearly denoting flight to quality.

This leads us to the question – Is there value in credit fund category today? While value is starting to emerge in select segments of the credit markets, we still believe it may not be an opportune time to enter the segment.

 

Spreads – The Guiding Light
 
As highlighted in our note (Value Investing - The AAA Way Part 2), spreads of AA rated bonds (over AAA) witnessed massive compression in FY18, thus signaling a better risk-reward trade-off in the AAA rated bonds. However, this trend has started to reverse for AA rated bonds. Over the last few months, in order to fund redemptions, credit-oriented funds have had to resort to selling some of their relatively better rated bonds (primarily AA and above rated bonds). This selling pressure, in an otherwise illiquid market has thereby led to widening of spreads in AA rated bonds.

On the other hand, ‘A category’[1] bonds continue to be sparsely traded, thereby not transmitting the full extent of stress witnessed in the credit markets. This has resulted in continued spread compression for ‘A category’ bonds. This divergence is especially bewildering given the overall risk aversion amongst market participants and general tightening of financial conditions.

 

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Price Discovery – Mirror on the Wall
 
The true valuation of any security can be ascertained from its traded value. Securities which don’t get traded in the market can continue to be at unrealistic valuations. The same can clearly be seen in the tables below. As can be seen from a sample of trade data, Credit bonds (AA category and below) which have traded over the last few months have witnessed a yield increase of over 100 basis points (reflective of stress in the credit market), whereas the non-traded bonds’ yields have moved up only by 30 basis points. In our view, this divergence in spread can be attributed primarily to illiquidity and not necessarily any change in credit profile.
 
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This, then, brings us to the rating split of bonds that have been traded (primary or secondary) recently. The credit-risk and credit-oriented funds[2] invest primarily in securities in AA category and below. Analysis of trades[3] since 1st Sep, 2018 clearly contrasts the illiquidity in lower rated (‘A category’ and below) bonds as compared to better rated bonds (AA category and above). As can be seen from the graph, over 60% of the AA category issuers in the underlying universe have witnessed a trade in their bonds since September 1st, whereas only 23% of ‘A category’ issuers therein witnessed a trade in the same period. This clearly points towards better liquidity & price discovery in AA bucket, relative to its lower rated peers. Needless to say, AAA rated bonds have seen near 100% trades.
 

2 Universe of credit oriented funds is as per Crisil classification of “Credit Opportunities Fund” prior to March 2018
3 Source for trade data is from Corporate Bond Reporting and Integrated Clearing System (CBRICS). Inter-scheme trades and trades below Rs. 5 crores have been excluded. An issuer is considered as “traded” if any one of its securities has witnessed a trade since 1st September 2018.  CBRICS is not necessarily exhaustive, but is reasonably representative of primary/secondary market trades.

 
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(Source: CBRICS, ICRA MFI Explorer)

 

Another interesting takeaway from the above graph is the sparse trading witnessed in the AAA(SO) segment, in spite of its high credit rating. These bonds provide an illusion of higher safety but suffer from similar illiquidity and price discovery as witnessed in lower rated bonds.
 
Relook at Credit Funds?
 
From a macro perspective, financial conditions have tightened and will only get further accentuated with the recent wobble in NBFC / HFCs. The resulting slowdown in aggregate lending could adversely impact overall growth and therefore is negative for credit markets. From a flow perspective, recent redemptions witnessed in credit-oriented funds have been sizeable and was last witnessed only in December, 2015. If such level of redemptions were to continue, they can have serious ramifications for spreads across the credit curve. Moreover, a lot of the lower rated issuers may face refinancing risk in a tightening liquidity scenario (see Annexure 1).
 
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(Source: ICRA MFI Explorer)

 

Key Takeaways
 

  • Spreads in AA rated bonds have started to recover. However, this has not been the case for ‘A category’ bonds due to lack of liquidity. As a result, spreads between A and AA bonds have fallen from over 2% to almost 1%.
  •  

  • Limited trading in ‘A category’ and below bonds results in limited price discovery relative to the rest of the market. As a result, bond valuations do not fully capture stress in credit markets and therefore lead to illusion of better performance in an otherwise weakening market.
  •  

  • Better liquidity and price discovery in AA category relative to lower rated credits provide a better risk-reward trade-off for investors.
  •  

  • Overall tightening of financial conditions is negative for the credit markets. This, coupled with adverse fund flows into credit oriented funds calls for caution from investors’ stand-point.
  •  
    Annexure 1: Large upcoming LAS (Loan Against Shares) maturities
     
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    Source- ICRA MFI Explorer

     
    A segment of the market which heavily relies on refinancing is loan against shares (LAS), given the absence of significant operating cash-flows at the issuer level.  Over the last few years, LAS structures have gained prominence given their higher yields amidst the strong flows in credit oriented funds. The next few quarters could witness sizeable bunching up of maturities as seen in the chart above. This wall of maturities could be a source of credit risk for the weaker/lower rated issuers in light of slowing flows into credit oriented funds and decelerated pace of growth in NBFC credit.

     

    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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    Sreejith Balasubramanian

    Global growth – The case for a Synchronous Slowdown
     
    After the synchronous global growth pick up in 2017, growth in the U.S. continued to accelerate and diverged from that in the EU, Japan and China. This was owing to the one-off fiscal stimulus, which included tax cuts and repatriation benefits to corporates, the impact of which is estimated to peak at the end of this year. We explore the case for a synchronous global growth slowdown ahead as the U.S. fiscal impact fades, the Fed continues to hike rates as expected and the economic climate in other advanced countries stays meek (Figure 1).

     

    Figure 1: Real GDP growth in the U.S., Japan, EU and China
     

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    Global growth – shifting to the slower lane?
     
    The PMI heat map below (Figure 2), a good proxy for manufacturing growth, suggests 2018 witnessed lower production growth vs. 2017 in most of the economies except the U.S. The shift is more obvious if we look at the regional aggregates. PMI readings for developed markets, particularly the EU, have decreased almost consistently since the beginning of 2018.

     

    Figure 2: Manufacturing PMI heat map – 2018 slips
     
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    Growth divergence vs. the U.S.
     
    Below, we gauge the extent of the current growth divergence in the EU, Japan and China vs. the U.S through a series of parameters.

     

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    Given the economic link through trade, Asian exports too have moderated in 2018 (Figure 11).

     

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    What lies ahead

     

    In 2018, we witnessed capital outflows and currency depreciation in many Emerging Markets, U.S. Fed rate hikes, rise in crude oil prices (which have eased a bit of late), initial signs of a slowdown in China and escalating tensions of a trade war. Cost of capital in many EMs became dearer due to interest rate hikes in response to the rapid currency depreciation and fear of pass through to inflation.

     

    Figure 12: U.S. Fed real GDP median projections (%y/y)
     
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    As the impact of fiscal stimulus on growth fades in the U.S. (Figure 12), China is tackling the after-effects of its own deleveraging-drive to curb shadow banking amid further tariff threats from the U.S. and the EU is dealing with Brexit related worries, a high budget deficit in Italy, etc. If 2019 does turn out to be a year of synchronous global growth slowdown, it is unlikely other economies, including India, will remain insulated from such deterioration in the global backdrop.

     

    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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