Markets were concerned in February about the government taking populist steps prior to the general election in May.
Concerns about the Modi government shifting from an economic to populist narrative ahead of May’s general elections saw February begin on a weak note. A modest income support of Rs 6000 (US$90) for small and marginal farmers and an income tax rebate for income earners below Rs 0.5 mn (US$7000) in the interim Union budget was just about good enough to raise this populist specter in the markets.
We note that a fiscal stimulus of INR 1 trillion is tantamount to a modest 50 bps of GDP. However, liquidity is likely to remain tight given that tax revenue collection growth will be challenged in the near term. The growth outlook is also clouded by the IL&FS impact on NBFCs, and curtailing credit availability to sub-prime markets and a slowdown in agri-economy due to low food inflation. This became evident as real GDP growth moderated from 7% in 2QFY19 to 6.6% in 3QFY19. Domestic growth concerns were magnified by weak global cues on risk of global slowdown and fears of a prolonged US-China trade war.
The markets took a breather as the Monetary Policy Committee (MPC) cut the repo rate by 25 bps to 6.25% and changed its stance to ‘neutral’. The sharp downward revision to the MPC’s inflation projections and increasing growth concerns have raised the possibility of 2 more policy rate cuts over next 2 meetings (next RBI policy meeting is April 4th). The MPC will also face no global liquidity pressures this year given increasing odds for fewer and intermittent rate increases by the US Fed.
The global market mood reversed mid-month led by gains in crude prices and repeated signals from US President Trump citing material progress in US-China trade talks. Domestic pressures arose from geo-political tensions between India and Pakistan post a fatal terrorist attack on an army convoy. Strong leadership at the center led to India react with air strikes on a terrorist camp in Pakistan. This led to incremental concerns on fiscal slippage and the yield on benchmark 10-Year G-sec rallied to its monthly peak.
Pressure on yields has subsequently eased as Pakistan de-escalated the crisis by releasing the Indian pilot after 3 days of captivity. At the same time, prompt and strong actions by PM Narendra Modi have perceptibly raised the feeling of nationalism and a desire of have a strong leadership and one-party governance. While it is simplistic to say that a single event has guaranteed PM Narendra Modi a second term, the odds of the BJP coming back for a second term are now at a 6-month high.
Fiscal concerns have kept the Foreign Portfolio risk appetite for debt markets in check. However, flows in the riskier equity markets picked up sharply and the INR has been resilient against a strong US dollar post the geo-political crisis, likely confirming the event as a turning point for the general election result. Domestic fixed income mutual fund flows remained extremely strong, continuing with January trend, possibly driven by the high near-term real yield opportunity.
In February, the benchmark 10-year yield on government bonds backed up by 7 bps from 7.62% to 7.69% (old series) and 13 bps from 7.28% to 7.41% (new series). Credit spreads widened marginally on a rising yield curve, with spreads on 10-year AAA and AA corporate bonds increasing by 4 bps and 5 bps respectively. INR-US dollar returns were flat for the month (-0.01%). High coupon income helped offset the rate backup and a modest increase in credit spreads helped contain the NAV markdown to 0.22% in INR terms and 0.23% in US dollar terms. The Fund’s cash levels, at 7.5%, have mildly increased given recent events and will be deployed in the coming weeks.
The Fund managers remain constructive on debt markets in 2019.
The RBI’s success with the inflation-targeting monetary policy and government’s drive to keep food inflation in check has resulted in significantly lower supply side inflationary pressures. On the demand side, the growth outlook is facing some pressure from tighter liquidity for NBFCs post IL&FS. We also see few, if any, rate increases by the US Fed indicating minimal from global liquidity pressures. This backdrop has strengthened the case for multiple rate cuts in India, the first of which came in early February.
The yield curve has steepened with shorter-end yields responding to inflation and RBI actions and the longer end backing up modestly led largely by anxieties around general elections in next two months. As noted previously the fiscal deviation is a modest one and we see this steepening as an opportunity to extend duration.
We expect a revival in corporate earnings, paced by fewer slippages, a reversal in provisioning for corporate banks, easing of liquidity as monetary stimulus trickles down, normalization in private and government consumption supported by structural demographics and increase in private capex with confidence on stable government for next 5 years. We see wider credit spreads as an opportunity to buy offerings by well-run corporates.