- Global tailwinds along with domestic monetary and fiscal stimulus restore growth optimism, fueling sharp risk market rallies.
- Growth slowdown, weak tax collections and increased government expenditures clog monetary transmission and further steepen the yield curve with limited gains for longer duration.
- High real rates, steep yield curve and wide credit spreads paired with benign inflation expectations and tax reforms supporting corporate profits drive our positive view on the total return opportunity in Indian debt markets.
Global risk markets are likely to remain volatile in the short to medium term, on Britain’s divorce from the EU and on the US-China trade war issue given unpredictability of the outcome, uncertainty of timing and higher risk premium for any fresh business investments. October did bring a measure of positive volatility on hopes of an interim trade deal between the US and China and on a delay in Brexit decision to January 31, 2020. An overtly dovish European Central Bank and a reluctantly dovish US Federal Reserve also helped. ECB leadership transitioned with the exit of Mario Draghi on October 31. But his parting comments set aggressive parameters for new round of quantitative easing to commence as Christine Lagarde assumes her leadership and will likely continue until core inflation rises significantly. The US Fed chair Jerome Powell has been proactive by acting swiftly and aggressively with three consecutive rate cuts of 25 bps each. However, the US Fed has endeavored continuously to dial back the odds of future rate cuts.
Indian equity markets mirrored the global trend, with additional local government stimulus measures. The government announced a 5% hike in dearness allowance valued at Rs159 bn per annum for central government employees and pensioners on October 11, fueling market expectations of cuts in individual income tax rates.
The Modi government provided decisive supply side fiscal stimulus on September 20 with a reduction in corporate tax rate from 34.9% to 25.2%. To spur additional capital formation, a special 17% rate was set for new companies starting new manufacturing facilities before March 2023. On September 13, several measures were taken to aid the real estate sector including relaxed external commercial borrowing norms for homes built under select schemes, lower interest costs for housing loans to government employees and establishing a fund to extend credit to select affordable/mid-income projects.
The mega merger of ten public banks into four on August 30 was followed with a capital infusion of Rs552 billion along with additional corporate powers. On August 23, the Indian Government promptly reversed the budget announcements with a series of market-friendly actions, including the rollback of a higher surcharge on capital gains tax for FPIs, speedier repayment of pending tax refunds to MSMEs, partial repayment of arbitration funds in contractual disputes between government enterprises and private entities and the launch of repo/external benchmark-linked interest rate products.
Unfortunately, gains were restricted to Wall Street, as weaker headlines plagued Main Street. The RBI revised down its FY20GDP growth forecasts from 6.9% to 6.1% but maintained its 2H inflation outlook at 3.5-3.7% primarily on higher food inflation. Infrastructure output, comprising eight core sectors with 40.3% weight in IIP, fell from -0.5% in August to -5.2% in September. August IIP growth was at -1.1% against an upward revised growth of 4.6% in July led by slowing momentum and adverse base effects.
Gross tax revenues in 1HFY20 have grown at a dismal rate of 1.5%, with only 5.2% growth in direct taxes and 2.2% decline in indirect taxes dragged by stagnant GST collections. Government spending has picked up pace post elections with total expenditure growth of around 14.1% in 1HFY20 adding to pressures on fiscal management.
The October 4 policy meeting saw the RBI deliver its fifth consecutive policy rate cut while stressing the need to ‘continue with an accommodative stance as long as it is necessary to revive growth’. However, weak growth prospects and fiscal concerns snarled monetary transmission and led to a steepening in the yield curve. October was no different with long duration 9-year and 13-year G-Secs rallying by 9 and 4 bps respectively. While corporate tax cuts have offered a profitability boost in near term, credit spread relief is asymmetric and contained to near term maturity debt. The spreads on AAA rated credit tightened by 7 bps for 1-year maturity, were flat for 5-year maturity and expanded by 6 bps for 10-year maturity. The absolute credit spreads are extremely wide in AA rating and below and have muddled the message beyond the current volatility.
Foreign Portfolio Investor flows were strong on global cues with US$2.1bn inflow into equities and US$0.7bn inflow into debt. Dated Brent prices were down by modest 0.9% and trade deficit pressures eased with Sept reading improving to US$10.9 bn vs US$13.4 bn in August. Surprisingly, this failed to drive currency strength as the INR depreciated by 0.1% despite 2.0% depreciation in Dollar spot index and 1.2% gain in JP Morgan Emerging Market currency index.
The Fund was down Indian rupee, INR 0.12% in INR terms but an incremental 0.08% depreciation in USD-INR drove the USD performance to negative 0.20%. The Fund's performance was aided by interest accruals in NBFCs and a re-rating in Bajaj Finance on recent equity recapitalisation through a Qualified Institutional Placement. The Fund performance was dragged by steep price declines in Indiabulls Housing Finance and Yes Bank and modest price declines in utilities – PowerGrid Corporation and Jamnagar Utilities & Power.
India’s growth engine has been slowed by a mix of many small issues, not a dominant core item and this had increased the risk of half-hearted government intervention. That said, we are encouraged by the prudent, multi-pronged approach taken by the government over last two months, while maintaining fiscal prudence at large. These measures are just a start and the recovery will be gradual, implying continuation of softer inflation-growth dynamics for the next few months.
We remain constructive on debt markets as both yields and spreads are expected to rally and drive positive returns. The yield curve remains steep offering potential for a long duration rally and a double-digit return opportunity here. The fund has about one-third of its book in long duration G-Secs to capitalize on this opportunity. The credit spreads remain closer to their widest levels in last 10 years, on top of a steep yield curve. These steep spreads are likely to normalise with higher focus on growth revival by monetary, fiscal and regulatory bodies of government. The Fund is poised to take advantage of these benign bond market conditions in the coming months