Looking Beyond Covid

India has finally bent the Covid curve. The number of daily new cases of Covid-19 has come down from a peak of ~97000 in mid-September to about ~45000 now. The economy is also recovering at a faster than anticipated pace. Most of the high-frequency data indicate that the economic activities have rebounded and now are closer to the pre-Covid levels.

At this juncture, it is imperative to evaluate what lies ahead for the economy and how that would impact the fixed income markets.

All is not well

Although the recent pickup in economic activity looks encouraging, there are doubts about its sustainability. The job market remains under stress and there has been a significant hit to household income. Under these circumstances, recovery in consumer demand may not sustain in the future. Capital investments are not showing any signs of recovery and the global environment doesn’t seem conducive for export gains.

The bigger threat to economic recovery is the second wave of Covid infections. Many countries are already witnessing the second wave of Covid-19 infections. India also runs this risk going into the festival season.

A Self-fulfilling Prophecy

Irrespective of the probability of the second wave, the economy will continue to need support from both the RBI and the government to come out of the Covid shock. The Government’s fiscal position has been stretched for many years, and there is limited headroom to provide any fiscal boost. In the current fiscal year the combined fiscal deficit of centre and state governments combined could jump to 12%-13% of GDP. Even in the next financial year, it would be difficult for the government to cut back on its expenditure in any material way.

Investors will look at the RBI to fill the demand-supply gap emanating from the excessive supply of government bonds.

On the other side, the RBI has been extremely supportive of growth in the last two years. It used all conventional and unconventional tools to keep monetary conditions easy and the financial system running. The policy repo rate has been lowered by 250 basis points (100 basis overnight rate has been cut by 290 basis points. The banking system has been flooded with liquidity.

Moving a step further, the RBI in its last monetary policy, committed to staying “accommodative” in the current financial year and into the next financial year. This kind of expectation setting could become a self-fulfilling prophecy.

What complicates the matter is the fact that the RBI is an inflation-targeting central bank. They are bound to react if inflation remains above their threshold level for a prolonged period. The RBI targets to keep CPI inflation between 2% to 6% band.

Inflation – ‘going down’ or ‘firming up’

In the post-Covid world, out of all the macro variables, inflation is the trickiest to forecast. Households have suffered a significant loss in their income and purchasing power. In theory, it should create a dis-inflationary impulse and bring the inflation down. But CPI inflation has moved up in the last six months. The headline CPI inflation has averaged at 6.8%, well above the RBI’s upper threshold.

Much of this jump in inflation is attributed to a sharp rise in food prices and adverse base effects from the last year. Within the food basket, the main driver of inflation has been vegetables which carries a strong seasonal impact.

Vegetable prices may come down with the arrival of a new crop in coming months. The adverse base effect will also dissipate in next 2-3 months. This is the reason why the RBI is going soft on inflation and forecasts inflation to come down closer to its target level of 4% by the year end.

Although RBI’s inflation outlook looks reasonable, there are concern areas in overall inflation dynamics. We are particularly concerned about the following three factors- (1) Elevated fuel prices and resulting increase in cost of transportation, (2) increase in import duties and inward-looking trade policies, and (3) increased government procurement of food grains keeping cereal prices high.

Apart from the above three, loose monetary and fiscal policy can also cause serious inflationary pressures when the economy revives.

However, at this juncture, the RBI is focused on reviving growth and seems ready to tolerate some inflation risks in the process.

What’s in store for bond investors?

The bond market is currently dealing with a problem of excesses. There is an excessive supply of bonds and there is are excessive interventions by the RBI to manage that supply. The RBI has been pretty successful in keeping market expectations and bond yields anchored. Nevertheless, it seems they are juggling with too many crystal balls at the same time.

In the last 2-3 months, the RBI has been extremely active in the debt markets, giving guiding signals to the broader markets. They are conducting OMOs and twists in government securities, OMOs in State Development Loans (SDLs), LTROs (long-term Repo operations) and not to forget out-of-way auction cutoffs and green shoes allocations. They have even resorted to anonymous buying of government bonds to align yields during the week.

Many of these measures are losing their effectiveness in terms of guiding market expectations and may become redundant over time. Additionally, it also runs a risk of giving wrong signals to the market.

In many segments of the Bond markets, yields are very close to their historical lows. The 10-year government bond yield has been below the 6% mark since the last RBI policy. As on November 12, 2020, it is trading close to 5.9%. There is scope for yields to go down from current levels somewhat. But this has to be a tactical position only.

Over the medium-term, the outlook will depend upon – (1) economic recovery prospects (2) inflation trajectory and (3) fiscal risks. The combination of these factors will determine the RBI’s response and the future trajectory of bond yields.

The monetary easing cycle is near its end and the fiscal situation has worsened to unprecedented levels. History suggests that Indian bond yields (10-year benchmark government bond) generally do not sustain below the 6% level for too long. The average yield for the last 20 year period is about 7.6%. The chart below shows that it is also volatile and broadly ranges between 5% and 9%. Currently, yields are closer to their long-term lower bound.

One factor which can drive bond yields lower is foreign capital inflows. Globally, bond yields have come down. In most of the developed economies yields are close to zero or even negative. Compared to this, the yield on Indian bonds looks attractive even after adjusting for potential INR depreciation.

Government is also keen on attracting foreign capital into Indian debt. They have made necessary changes in the rules for foreign investments to get into global bond indices. Given the high global liquidity and low yields in developed economies, India could attract sizeable foreign inflows in domestic bond markets.

Portfolio Positioning – Tactical vs Structural Trade

In the Quantum Dynamic Bond Fund (QDBF) portfolio, we continue to focus on tactical trading opportunities within a narrow range. QDBF does not take any credit risks and invests only in sovereigns and top-rated PSU bonds, but it does take high-interest rate risk from time to time.

Given the yield curve is already very steep (Chart – VII ) and the RBI is actively intervening in the market to protect long bond yields from rising, we are positioned at the longer end of the maturity curve which is offering better accrual yield.

This is a tactical position that can change based on market developments and new information flows. Given the objective of our fund stated in the name itself – we retain our right to remain dynamic in our portfolio construction as we remain cognizant of these risks on the horizon.

We understand the economy and markets are currently adjusting to an unprecedented shock. There are too many moving parts and things are still evolving. Thus, any forecast about the future is susceptible to change based on policy responses from the government and the RBI and the changes in global markets. We stand vigilant to review our outlook as and when new information comes. Nevertheless, it would be prudent for investors to be conservative at times of heightened uncertainty.

Investors should lower their return expectations from fixed income – as money market yields, fixed deposits will remain low, and potential capital gains from long bond funds will be muted.

Credit Crisis is not over yet

We reiterate our view that the credit crisis in the bond market is not over yet. The Indian economy has faced a severe jolt due to a national lockdown. This has significantly weakened the debt servicing capacity of many companies and individuals. This could create a negative spiral in the economy and hence in the loan and bond markets. We see a high risk of rating downgrades and defaults in the next two years.

In this scenario, it would be prudent for investors to avoid excessive credit risk in their debt exposure.

Name of the Scheme	This product is suitable for investors who are seeking*	Riskometer
Quantum Dynamic Bond Fund (An Open Ended Dynamic Debt Scheme Investing Across Duration)	• Regular income over short to medium term and capital appreciation • Investment in Debt / Money Market Instruments / Government Securities

* Investors should consult their financial advisers if in doubt about whether the product is suitable for them.

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