Summary

• A disruptive combination of global and domestic headwinds impacted India’s financial markets across all asset classes in September. On the global front, crude price increases and risk aversion from foreign portfolio investors exacerbated currency weakness. Domestically, a loan default by Infrastructure Leasing & Financial Services (IL&FS), an AAA-rated diversified financial conglomerate, triggered a money market liquidity event.
• India’s government authorities and the Reserve Bank of India (RBI) have taken steps to calm the markets, mainly through large scale intervention to promote domestic liquidity and currency stability. The sustainability of domestic liquidity relief measures will depend on IL&FS’s new management team’s ability to execute its plans to reshape the company.
• Events are now well known and largely discounted but volatility is likely to remain elevated for the balance of 2018. This will prevent investors from committing significant capital, it’s now all about execution.

Market update

The month had an ominous start as escalating trade disputes, and crude price gains exacerbated currency weakness. Currency concerns gave rise to fears of more extreme RBI tightening and factored into risk management decisions as foreign portfolio investment (FPI) selling intensified.

Mid-month, a loan repayment default by IL&FS led rating agency ICRA to downgrade the company rating. This triggered fears of broad contagion for the Non Banking Financial Companies (NBFC). Redemptions in liquid mutual funds and indiscriminate corporate bond selling followed, leading to yet more pressure on NBFCs and fears of a vicious cycle. September also saw draconian measures taken by the RBI on select financial companies that led to a market value decline for India’s most widely held sector:

• Yes Bank (limited period extension to MD & CEO, with directive to search for a successor)
• Bandhan Bank (freeze on CEO remuneration and a new branch ban for not reducing promoter group shareholding as required under the licensing condition)
• Merger of 3 government owned banks (Bank of Baroda, Dena Bank, Vijaya Bank)

The final week of September was marked by aggressive policy moves. The RBI provided durable liquidity via open market operation (OMO) purchases of G-sec and enhanced the Facility to Avail Liquidity for Liquidity Coverage Ratio (FALLCR) from 11% to 13% of deposits. The government also acted swiftly to replace the board of IL&FS with highly rated professionals from the private sector to shore up operations.

These significant liquidity events overshadowed India’s strong macro-economic data:

• CPI inflation moderated to 3.69% in August compared to 4.17% in July led by softer food and core inflation.
• The monsoon season closed with sub-normal rainfall but advance estimates for monsoon crop production indicate 5.1% YoY higher food grains production.
• GST revenues are running short of the budgeted run rate but there is meaningful government spending restraint.
• Fiscal discipline and an ability to mobilize funding through small saving schemes helped the government lower its 2HFY19 borrowing program by approximately Rs200 billion.

Performance

The yields on the benchmark 10-year GOI bond rose by 7 bps to 8.02%. Despite money market stress, corporate bonds were relatively resilient with a modest 6 bps increase in spreads for AAA-rated 10-year paper. This modest tightening was offset by higher yields earned in the corporate bond book and led to a modest 0.14% gain in net asset value (NAV) in Indian rupee (INR) terms. With respect to currencies, a 2.16% INR decline versus the US dollar yielded a NAV loss of 2.02% in US dollar terms.

Year-to-date, the Fund’s NAV is up 1.35% in INR terms and down 10.70% in US dollar terms when adjusted for the 11.88% IN rupee depreciation.

Strategy

The Fund will maintain a reactive posture given the uncertainty in crude markets, potential escalation of trade disputes, uncertainty around India’s 2019 general elections and incremental fallout from the IL&FS liquidity event. The Fund has no direct exposure to IL&FS and we believe that our NBFC holdings are in conservatively capitalised and well managed firms, we are redoubling our credit work and due diligence on these and all other holdings. In our view, the INR weakness is extreme, and we expect a sharp rebound, but this will depend on increased clarity and resolution of the macro issues impacting India’s financial markets. Rest assured, we are poised to react in a nimble and decisive fashion when are convinced that the fog of macro risks is lifting.