Debt Outlook
04th January, 2012
Arvind Chari- Fund Manager (Debt)
Market Round up
The year 2011 would go down as one of the toughest years in Indian fixed income investing for bond traders. Stubborn inflation, high fiscal deficit and an aggressive central bank led to sharp rise in market interest rates, which meant high losses in bond portfolios.
On the contrary, as predicted last year in our outlook, 2011 happened to be a good year for investors in fixed income products. Interests on fixed deposits scaled decade highs providing relief to the multitude of savers across the country who invest a large portion of their savings in fixed income products. Though the high interest rates on offer have failed to beat inflation, which means the returns on deposits are lower than the rate of inflation, the absolute levels of 9-10% have enticed investors.
Regular readers of the Quantum view would recollect that we have been recommending a shift in fixed income investments from FMPs into active income funds to benefit from capital gains or extending the maturity tenor of one’s fixed deposits/FMPs to 2-5 years to lock into higher rates on offer for a longer period. This comes out of our view that market interest rates have peaked and interest rates would probably head downwards in 2012 as inflation falls and the RBI shifts its focus towards maintaining the economic growth rate.
A year in review:
The year took off with some very disturbing inflation data points. Food inflation spiked sharply in December 2010 on account of unseasonal rains and the continued US Federal Reserve monetary stimulation (Quantitative Easing - QE II) impacted global commodity prices, leading to a sharp and sustained rise in manufactured product inflation. The inflation trend gained dangerous proportions and forced the RBI to adopt an aggressive stance to manage inflation. In 2010, the RBI had hiked the repo rate by 150 bps (1.5%) as a step towards normalizing the interest rates to support growth and manage inflationary expectations. However, 2011 was all about fighting inflation as they hiked the repo rate by a total of 225 bps (2.25%) in a span of ten months. The rate hikes were clearly having its impact on the growth trend and sentiment but the RBI rightly focused on its efforts to quell inflation. Interest rates rose across the board and banks revised the lending and deposit rates upwards. Base rates for most banks are well in double digits.
On the domestic front, the biggest disappointment was from the government. The inability and lack of decision making across all spheres over the years has finally taken its toll. The government almost appeared clueless and in self-denial with the current state of events. Our biggest grouse has been on the state of the government’s fiscal condition. Nobody believed the government’s initial target of fiscal deficit of 4.6% to GDP for FY ‘12, but the manner in which they have allowed the fiscal hole to deepen this year has been extremely disappointing. High fiscal deficit continues to spook inflation and dampen investment sentiment.
To add to our domestic woes, the continued imbroglio over the European sovereign debt crisis has meant that global risk appetite has remained low thus impacting capital flows into sensitive markets like India. We have seen the Rupee weaken to all time lows thereby affecting sentiment and increasing problems for importers and Indian corporates with Forex liabilities. Although we believe that the Rupee move has been excessive and the fall could have been controlled with measures earlier, but it underlines the point that a country which runs high current account deficits, requires external capital flows as funding and hence needs to ensure that the domestic economy and sentiment remain conducive to attract foreign investment.
Macro Outlook:
The Indian economy will slow down from its expected +8% GDP growth level to the new consensus of 6.5% - 7.5%; because of global and domestic factors. We have always maintained that given the current level of infrastructure, India’s sustainable trend growth is 6.5%. At that level, the requirement of external capital to fund the growth is limited (maybe 1.5% - 2.0% of GDP than the current 3.0%). In addition, inflation and fiscal deficit would be in control if Indian policy makers accept that in a scenario of global slowdown, a 6.5% growth is a good bargain and it is beneficial to remain within one’s means than stimulate and fuel excessive credit bubbles and inflation.
With Savings to GDP of 33%, Indian can grow at 6.5% keeping current account deficit within 2% of GDP ; fiscal deficit below 5% and inflation at its long term average of 5.5% . We believe that policy makers have begun to realize this fact and its benefits and thus we had the RBI aggressively hiking interest rates to quell inflation in the last year and a government that is finding it difficult to go overboard on spending despite the apparent weak economy. The finance minister has realized that India has little fiscal room to stimulate this time around unlike the period post Lehman where overall fiscal deficit deteriorated from 2.9% to 6.5% between FY ‘09 and FY ‘10 to accommodate the impact of global recession.
We are thus currently undergoing the painful phase on having tried to fund a seemingly impossible 9% growth through external capital with the consequent high inflation and high fiscal deficit now eroding global and domestic investment confidence. India needs to boost its ‘Animal spirits’ - take its private investment / GDP back to the above 15% mark from the current 11%. But for that to happen, this period of slowing down is essential to manage inflation and control fiscal expenditure.
Our studies show that India has had 6 coalition governments out of the last 9 governments since 1980 and we have still averaged 6.2% GDP growth. We do not have any reason to doubt this fact and expect India to grow alteast at 6.5% on its domestic consumption, domestic infrastructure development and domestic services industry driven economy. Therefore, our squabbling and indecisive politicians would deprive us of the 9% macro fairy tale but India to date remains a land of micro opportunities and growth. So while the macro picture appears hazy, the micro set up remains strong on account of rural consumption and incomes.
Monetary and Fiscal Policy:
We expect the RBI to change its monetary policy stance in early 2012 by shifting its focus towards managing growth than inflation. Recent economic data, be it GDP, industrial production, Capex activity, service activity; continues to signal a significant downturn which needs to be managed. High interest rates and tight liquidity are dampening demand at the margin and given the fiscal challenges of the government, the onus on managing growth expectations and improving investment sentiment will fall squarely on the RBI.
We have highlighted earlier that the rate hiking cycle has peaked, and the RBI would initiate its easing measures. The RBI has already initiated its Open market operations (OMOs - in an OMO purchase transaction, the RBI buys back government bonds directly from the market thus infusing liquidity) to ensure that liquidity remains within the (+/- 1%) of net system deposits. The usage of OMO also helps the RBI add liquidity to counteract any tightening from Forex market intervention. We expect the RBI to continue with its OMO program as they are tactical, less permanent and do not indicate change in monetary stance.
However, the sharp fall seen in food inflation in November and December of 2011 will provide necessary room for the RBI to adopt a change in stance in its January 2012 policy through a cut in Cash Reserve Ratio (CRR) and/or by direct rate cuts signaling an easing policy action going forward.
We expect inflation to ease below 6.5% by March end, giving RBI enough room to cut repo rates and add liquidity. We expect a CRR cut in the January policy post December’s inflation number, and rate cuts in February. Overall, we expect RBI to cut the repo rate by 100 bps during the first half of 2012 and add further liquidity if credit growth collapses.
Fixed Income Investments:
Indian bond yields have rallied quite sharply (yields have fallen, bond prices have gone up) in November and has continued the Bull Run in December 2011. The 10-year government bond yield has fallen from 9% at the start of November to 8.3% in December due to weak economic data, falling inflation and RBI OMO operations.
Given our overall view of further rate cuts and liquidity additions, we can expect the trend to continue going into the first half of 2012. We have also seen yields falling in the shorter end of the government and corporate bond curve on the back of demand from foreign investors and mutual funds.
Risks:
Fiscal Policy continues to remain the dominant risk for Indian bond markets. The government, challenged by lower tax revenues and poor expenditure management, looks set to borrow more than budgeted and the extent of it can come as a negative surprise to the bond markets. In addition, the markets would be keenly awaiting the fiscal deficit number for FY 2013 to be announced at the end of February 2012, which would determine the sustainability and extent of the current evolving bond rally.
Oil prices remain high and on the event of escalation of global economic tensions in Iran, Brent crude can trend higher impacting India’s trade deficit, inflation and fiscal deficit.
The Indian Rupee remains under pressure and the sharp depreciation seen in recent months would lead to some impaired balance sheets and higher cost of imported products. A renewed bout of global risk aversion emanating from the ongoing Euro area crisis can lead to further depreciation in the INR and instability in the macro economy.
Keeping that in mind, we have been recommending a gradual move towards active investments in fixed income from passively investing in Fixed Maturity Plans (FMPs) and fixed deposits as rates appeared to peak out. We believe that even the current market levels provide a good opportunity to increase investments in actively managed debt funds to benefit from capital gains arising from the increase in bond prices as yields fall further. We have also been highlighting the fact that, if liquidity permits, increase the duration of your fixed deposit to lock into higher rates on offer for longer maturity in case you do not invest in mutual funds to manage your exposure to fixed income instruments.
Disclaimer:
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