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Investment Insights

Suyash Choudhary

The elections handing over a continued strong stable government is welcome relief to market participants. In particular, it will help keep India’s country risk premium stable amongst its peers. With this out of the way, local policy can afford to start focusing emphatically on the evolving macro narrative. This is marked by a synchronized global slowdown which has been underway since late last year and has caused major central banks to start leaning dovish since early this year. Moreover, India’s own growth and inflation dynamics remain soft as well. The Monetary Policy Committee (MPC) has so far responded with two rate cuts, but there is little that has been achieved by way of transmission.

 

The following recent developments are noteworthy:

 
1. While the domestic auto sector has been showing a significant slowdown for some time, there is now a sense of the consumption slowdown spreading more generally as well.
 
2. The credit aversion in parts of the financial system that seemed to be stabilizing earlier in the year seems to have been aggravated again recently.
 
3. The global narrative on growth which was beginning to look somewhat optimistic again post the US Fed pivot and recent Chinese expansion of credit has turned murky once more with hopes around a US – China deal having been disappointed for now.;
 
The Government’s Constraints

 

There is little doubt then that India, alongside most of the world, is in the midst of a cyclical slowdown. It is noteworthy that this slowdown is despite the fiscal ‘expansion’ that has happened over the past year or so. Most of this expansion seems to have happened almost involuntarily as revenues on GST have meaningfully undershot expectations. Furthermore, with the likely undershooting of FY19 tax revenue numbers from even the revised estimates in the budget, the year on year growth rates implied in the FY 20 interim budget numbers look very aggressive.

 

It is clear then that there is very little room for the government to step up spending in any meaningful manner in the immediate future ahead. In fact in the interest of credibility it would be prudent for the government to restate the fiscal deficit taking into account the actual revenue outcomes for this year and the substantial usage of below the line items in financing the budget. It is to be clarified that some deployment of counter-cyclical fiscal expansion given the macro narrative wouldn’t be amiss at all. However, the incremental room as discussed here is limited. More importantly, the bond supply associated with this level of deficit is leading to genuine crowding out and elevated nominal bond yields despite very low inflation. Thus, there is a macro impact of elevated long term real yields that needs to be taken into account when thinking about an incremental fiscal stimulus. Some avenue for extra spending may come about if the government gets a significant transfer of capital from RBI. The government may also focus on more substantial monetization of its assets in order to increase spending without appreciably breaching a fiscal consolidation framework. Ultimately, however, true fiscal flexibility will have to wait till recent tax reforms bear fruits respecting the so-called ‘J’ curve, especially in the case of GST.

 

Player One: The RBI

 

The maximum ‘room’ as it were resides with monetary policy currently, in our view. Consumer Price Index (CPI) has tracked lower than the mid-point of the official target band for a while now. Furthermore, it is likely to remain relatively benign in the foreseeable future as well, even accounting for some upside to the RBI’s assessment for the year ahead. Major global central banks have turned dovish on the margin.  Our election verdict will serve to possibly compress India specific risks somewhat versus other similar emerging markets. The local growth narrative is one of a visible slowdown. Various sectors like real estate and telecom remain relatively stressed and income growth remains muted. Sections of the financing market are clogged and may have served to prematurely impact the consumer leverage cycle which, in the absence of any significant upturn in incomes, is possibly what is visible now in slowing consumer demand. In short, in the real world it is difficult to worry about demand side inflation at least in the near term. Despite this scenario, real rates remain high even at the short end and policy stance remains neutral. Also even though core liquidity has turned positive for now, the RBI’s stance on it remains unclear to market participants.

 

We had highlighted in a recent note (https://www.idfcmf.com/insights/transmission-impossible-a-discussion-on-monetary-policy/) 3 areas where, in our view, there is scope for RBI (and to some extent MPC) to more fully examine and utilize the tools available. Drawing from this framework, we think it is desirable for the MPC to shift monetary policy stance to accommodative. Furthermore, from an RBI standpoint, an indeterminate stance on liquidity (though backed over the past few months with stepped up efforts at liquidity creation) may no longer be enough. Market participants need to be assured of sustained positive liquidity for near term spreads to come down. The situation in some sense is similar to 2016 where Rajan had reacted by officially clarifying in the April 2016 monetary policy review to “continue to provide liquidity as required but progressively lower the average ex ante liquidity deficit in the system from one per cent of NDTL to a position closer to neutrality”. In our view, the time may be opportune to similarly officially state in the monetary policy review the intent to move liquidity to some sort of surplus (say, 0.5 or 1 % of NDTL). The shift in stance combined with this stated intent of affirmative action on liquidity may go a long way in improving transmission at least so far as the money market curve is concerned. Also given the very narrow policy corridor now, such a move cannot be interpreted as ‘back door’ policy easing by any stretch of the imagination.

 

The Objections to Monetary Easing (And Why We Don’t Agree With Them)

 

Two objections that are sometimes made to additional monetary easing are as follows:

 
1. It won’t matter to the NBFC issue:  There are two aspects to the problem currently. One, near term spreads are extremely volatile and generally elevated. Two, the credit spread over the risk free has widened significantly for a section of the market. To be clear, any change to liquidity stance is only aimed at addressing the first issue. As an example, spread of 3 month bank CD to repo rate had recently widened to almost 125 bps over the repo rate, despite it not being busy season any more. It has fallen since largely on market’s expectation of further monetary easing. This can be anchored more sustainably with the change in liquidity stance. The credit spread issue will work out over longer periods of time as balance sheet issues get addressed and risk perceptions stabilize. Unless there is a system destabilization risk (which doesn’t seem to be the case currently), there is little role for RBI here without inviting a moral hazard problem.
 
2. The previous stimulus of 2009 ended badly: The 2009 stimulus was of an extraordinary degree across fiscal and monetary policy, and wasn’t pulled back even when it was clear that the economy no longer needed it. The lesson is, of course, relevant. However, it is a stretch to not act now for fear of this repeating. The government has largely adhered to a fiscal consolidation framework despite pay commission pressures in the past few years. Challenges have recently surfaced mostly owing to GST disappointment but by no means are stability threatening. On its part the RBI/MPC are committed to a CPI targeting framework now and will presumably counterbalance any stimulus should CPI targets look sustainably under threat in the future.
 

Conclusion

 

The election mandate of a continued strong government  will help contain sovereign risk premium and allow policy to focus on the local narrative of slowing growth. The government seems to have little fiscal space given recent pressures and must balance incremental deficit expansion with the economy-wide cost of higher real long term rates. The RBI/MPC, on the other hand, have more room and should respond now with a more decisive focus on the guidance tool for both rates and liquidity. This, in our, view has the maximum chance to influence transmission. The view remains bullish on quality bonds (sovereign, SDL, AAA) and cautious on lower rated 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 security may or may not continue to form part of the scheme’s portfolio in future.  Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. 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

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Amidst this season of poll promises, one common scheme announced by both the Bharatiya Janata Party (BJP) and the Indian National Congress (INC) is income support through direct cash transfer. Wrapped in different names, sizes and targets, the broad cost and the operational feasibility of these plans have already been widely debated. We endeavour to gauge the impact of these plans, if implemented, on the core economy, through growth, fiscal and inflation. Given the impact is entirely contingent on 1) the time taken for maximum or full implementation and 2) the level and pace of operational scaling-up during this period, we examine scenarios which depict possible paths of implementation and the corresponding macroeconomic impact.
 
Growth
 
According to a September 2017 study published by the Development Research Group (DRG) of the RBI, for a 10% rise in government expenditure, direct consumption boosts real Gross Domestic Product (GDP) by 85 bps in the first year vs. transfers to households (whether to all or only the bottom 70%) only by 30 bps, with the latter’s impact declining over time. The reasons are:
 
– Unlike direct government consumption, transfer increases the disposable income of households (HHs), part of which is saved (also as cash) depending on the marginal propensity and only the rest is spent on consumption after paying any taxes, etc.
 
– HHs consume more agricultural and industrial goods, which have a lower weight in output (~46% in FY19), while government consumes more services. This reduces the impact of transfers on GDP, tax revenue growth, and therefore investments which determine future growth. One could argue the resulting lower fiscal balance creates higher growth impulse, but 1) the damper direct GDP impact more-than offsets this and 2) the lower skilled and semi-skilled employment generated via household expenditure reduces second round demand creation and future growth.
 
If we paint inflation with the same brush, the impact on the Consumer Price Index (CPI) from any income support plan would be higher than direct government consumption as goods have a much higher weight (76.7%) in the inflation basket than services (23.3%). Further, given the sharp drop in food prices (read farm distress) in the last few years, any incremental consumption could be more heavily skewed towards food items, potentially channelling reflationary pressures there. Rural food & beverages have a weight of 29% in the All-India CPI basket.
 
So far, the merit of direct cash transfers has largely been evaluated only vs. the current system of multiple subsidies, as it is widely acknowledged to plug leakages and thus better for growth. However, the impact on growth of direct transfers vs. other forms of public/private measures needs to be studied and debated more.
 
The fiscal, consumption and inflation impact
 
The BJP’s Pradhan Mantri Kisan Samman Nidhi (PM-KISAN), initially launched targeting families of ‘Marginal & Small’ farmers as per the FY20 interim budget, will be extended to all the farmer families as per its election manifesto (Figure 1).
 
Figure 1: BJP’s PM-KISAN
 

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The key questions are 1) what is the fiscal cost?, 2) how much will this boost household consumption expenditure and 3) what will the likely CPI impact be? The total fiscal cost will be 0.42% of GDP in FY20, if implemented fully (Figure 1). Even if we assume the number of marginal & small land holdings increases in the next agriculture census (which will have data for FY21) by the same amount it did from 2010-11 to 2015-16, the additional cost will only be ~0.02% of GDP. Moreover, the 2020-21 agriculture census is not likely to be released before 2023, based on previous releases.
 
To answer the second and third questions, we need to ascertain households’ Marginal Propensity to Consume (MPC), which is the amount of consumption spending created from every additional rupee of income. The RBI study mentioned previously notes the top 30% of HHs contributed to 84% of HH savings, implying very high consumption for HHs in the bottom 70%. It also notes 68% of all HH earnings is spent on consumption (implying high average propensity to consume). Our own estimate of MPC, derived using linear regression of growth in domestic HH consumption expenditure and gross disposable income as per the new national accounts series (R2 = 0.74), was ~87%. Assuming a slightly conservative MPC of 80%, Figure 2 depicts the likely increase in private consumption generated by the plan, over and above the previous five-year-average growth of 12% (0.53-0.62%), and the likely CPI impact (15-45 bps) ceteris paribus and depending on the pass-through from consumption growth to CPI.
 
Figure 2: Likely impact of BJP’s PM-KISAN scheme on consumption and inflation

 
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Source: CEIC, Agriculture Census 2015-16, India Budget, BJP election manifesto, IDFC MF Research

 

The INC’s Nyuntam Aay Yojana (NYAY) guarantees a cash transfer of Rs. 72,000 per year to ~ 5 crore (the poorest 20%) families, after a year of design, pilot & testing. INC estimates it to cost <1% of GDP in the first year of implementation and <2% of GDP in the second year and thereafter. We explore multiple scenarios, with varying level and pace of implementation, to gauge the likely economic impact (Figure 3).
 
Figure 3: INC’s NYAY
 

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Source: India Budget, INC election manifesto, IDFC MF Research. Note: In each of the three scenarios, we assume 3% of people move out of poverty each year, 5% of FY20 subsidies are discontinued from FY21 and the nominal GDP grows by 11% each year.

 

Again, assuming an MPC of 80% as before, Figure 4 depicts the likely increase in private consumption generated by the plan, over and above the previous five-year-average growth of 12% (0.48-1.95%), and the likely CPI impact (12-146 bps) depending on the pass-through from consumption growth to CPI.

 

Figure 4: Likely impact of INC’s NYAY scheme on consumption and inflation
 

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Source: CEIC, India Budget, INC election manifesto, IDFC MF Research. Note: PFCE is Private Final Consumption Expenditure
 

• Needless to say, the more time it takes for maximum implementation, the lesser the cost as nominal GDP grows and people move out of poverty each year. The possible disincentive for people to move out of ‘poverty’ to remain beneficiaries of the scheme is not considered here for the sake of simplicity
 
• The CPI impact is also lower and smoother (i.e. more evenly spread out) with higher implementation time
 
• While the PM-KISAN scheme is already in the execution phase, the NYAY scheme is still in the strategy & design phase where the finer details such as sources of funding, non-merit subsidies to discontinue, process to identify and verify the target population, estimate of the number of people who move above the scheme-threshold each year, etc. are being chalked out
 
• Therefore, we see the range of outcomes for the fiscal and inflation impact of NYAY at this stage is higher than for PM-KISAN, although the quantum of impact seems higher due to NYAY’s higher transfer However, the actual economic impact will entirely depend on the final size of target population identified, the level and pace of implementation explored using the above scenario-based framework
 

Ultimately, it is worth reminding ourselves all economic resources are limited. For every additional rupee one spends, a rupee is parted with or not received by another. It is essentially only channelisation, but this bigger picture might become visible only in the longer term. Thus, for a holistic assessment, one needs to also consider the longer term and the population not immediately benefited by such government schemes. We need to see more than meets the eye.

 

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

In the aftermath of the IL&FS default in September’18, we have witnessed a steady rise in credit spreads. To recap, the first round of spread expansion was observed in the more liquid AA bonds owing to better price discovery (refer to the previous note Qu’AAA’lity, Qu’AA’lity or Qu’A’lity? – An Update on Credit Markets). This has now been finally followed by an expansion of spreads (albeit slowly) in the lower rated/ illiquid segments. Does this spread expansion provide investors with an attractive entry point into credit-oriented funds?

 

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Spread expansion in lower rated bonds is perhaps overstated
 
A deeper analysis of the recent round of spread expansion in the lower rated space throws up some interesting observations. Firstly, a large part of this expansion has been driven by sharp downgrades witnessed by a few NBFC/HFCs from AAA/AA+ to A. Such sharp rating downgrades could perhaps overstate the actual expansion of spreads. Secondly, the stress witnessed in the Loan-Against-Shares (LAS) segment has also been a contributor to this expansion. Adjusted for these two segments, we notice that the effective spreads in the ‘A category’[1] is only 3.09% (as against 3.77%), almost 70 bps lower!

 

Further, the spread expansion in the ‘A category’ could be viewed as nothing more than a catch-up post the artificial compression witnessed in December 2018. This is clearly visible in the chart below, where we notice that spread between A and AA rated bonds have only normalised to levels last witnessed a year back. Keep in mind, the credit environment last year was far more benign as compared to today. Hence, one would have to expect a further expansion in ‘A category’ spreads reflective of the current environment.

 

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Outflows from Credit oriented funds continue
 

As we have highlighted in the past, a key determinant for credit spreads is the pace of flows into credit oriented funds[2]. Post the IL&FS default in September 2018, the trend of outflows continue unabated as can be seen in the chart below.

 

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In addition, several Credit Oriented FMPs totalling Rs. ~9,000 Cr are due for redemption this financial year which in a way can be construed as further redemption from the credit category. Hence, the total outflow from both open ended and close ended credit schemes is sizeable.
 
In this backdrop of redemptions, we notice that some schemes are also getting increasingly concentrated towards lower rated assets. In fact, as of March 2019, a total AUM of over Rs. 20,000 Cr (across ~25 open ended schemes) have concentrated exposures of greater than 10% to a single issuer rated A+ or below. The chart below highlights the total AUM of open ended schemes with relatively higher proportion of lower rated asset (A+ and below).

 

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2 Universe of credit oriented funds is as per Crisil classification of “Credit Opportunities Fund” prior to March 2018
 
It is noteworthy that higher exposure to lower rated assets is not limited to Credit Risk funds alone. As we can see in the chart above, schemes outside the Credit Risk category also have outsized exposures to lower rated assets.

 

What now?
 
It may be premature to view the recent expansion in spreads as an investment opportunity. The credit market is still grappling with concerns around redemptions and concentration risks coupled with sharp deterioration in perception of certain companies. Further, the recent expansion in low rated spreads may be nothing more than delayed harmonisation of artificially compressed spreads witnessed in the past.

 

In our view, it is vital for some of the above risks to show signs of abating before investors revisit this category. Needless to say, once the opportunity were to present itself, it is essential for investors to participate via relatively liquid/tradable bonds in the AA category rather than the lower rated category (rated A and below). Recent experience suggests that Mutual Funds may not necessarily be the appropriate vehicle for low rated/complex structures given its inherent illiquidity and high risk.

 

Key Takeaways

 

• In the aftermath of the IL&FS default in September’18, we have witnessed a steady rise in credit spreads. This spread expansion is now visible even in the lower rated/illiquid bond space.
 
• However, the recent spread expansion in lower rated/ illiquid bonds could perhaps be overstated. This is because, two stressed segments namely weak NBFC/ HFCs and LAS have contributed significantly to this expansion. Adjusted for these two segments, the spread expansion is not so stark.
 
• Further, this spread expansion in lower rated bonds may be nothing more than delayed harmonisation of artificially compressed spreads witnessed in the past.
 
• The sustained outflows from credit oriented funds continue to have a bearing on spreads. In addition, several Credit Oriented FMPs totalling Rs. ~9,000 Cr are due for redemption this financial year which in a way can be construed as further redemption from the credit category.
 
• The credit market is still grappling with concerns around redemptions and concentration risks coupled with sharp deterioration in perception of certain companies. It is vital for some of the above risks to show signs of abating before investors revisit this category.
 

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 security may or may not continue to form part of the scheme’s portfolio in future.  Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. 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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