Global debt markets performed strongly in January, however, Indian debt markets bucked the global trends due to a rise in crude prices, among other things.Summary

• Global debt markets performed strongly in January due to conciliatory communications from the US Federal Reserve and the European Central Bank about future policy adjustments, as well as increasing concerns about global growth and benign inflation readings.
• Indian debt markets, however, bucked the global trends due to a rise in crude prices and concerns about deficit spending ahead of the May 2019 elections.

• Notwithstanding those concerns, the Fund is constructive on debt markets in 2019, given both benign inflation expectations resulting in high real rate as well as due to high-grade credit spreads which remain attractive.

Performance

In January, the benchmark 10-year yield on government bonds backed up by 24 bps from 7.37% to 7.61%. Corporate bonds traded better, with spreads on 10-year AAA and AA corporate bonds easing by 19 bps and 33 bps respectively. Due to coupon income and the spread rally offsetting the rate backup, the Fund registered in a modest gain in NAV at 0.08% in Indian rupee terms. However, due to the 1.8% rupee-US dollar depreciation, US dollar NAV was marked down by 1.76%. The Fund used this dislocation in government bonds to buy long duration government securities (G-secs). Accordingly, the Fund’s substantial cash holdings were trimmed to 4.6%.

Market update

The month started on a subdued note. Concerns about economic weakness in China continued to mount, led by deterioration in the manufacturing sector and no progress on US-China trade talks. In the US, GDP growth was ratcheted down modestly, partly due to US-China trade concerns and partly due to lower consumer sentiment from weak financial markets and the temporary US government shutdown. Europe struggled as well, plagued by the risk of a delay in Britain’s exit from the European Union, emerging Eurozone capacity constraints, Italy’s debt and an overall slowdown in global growth. China opted to ramp up fiscal stimulus to support its economy.

The uncertain global growth environment led the International Monetary Fund (IMF) to downgrade its global growth forecast from the 3.7% in its October outlook to 3.5% in January.

Despite global tailwinds, a steep decline in Consumer Price Index (CPI) and a proven track record of inflation targeting, Indian debt markets have bucked the global trends this month.

The key drivers of this were:

• a sharp reversal in crude prices after a steep fall in the previous quarter
• shortfalls in monthly GST collections
• fears of a wider fiscal deficit at center and state levels in the run-up to Indian general elections in May 2019
• concerns on populist tendencies diverting the government funds from capital expenditure to either income support or consumption subvention
• an increase in odds of the left-leaning, united opposition defeating the incumbent Bharatiya Janata Party (BJP) led government.

Lastly, investors curbed their risk appetite ahead of the first Monetary Policy Committee meeting in January under the new Reserve Bank of India (RBI) governor. Foreign Portfolio Investors sold debt worth US$367 million in January. Offsetting that, domestic flows were extremely strong, but that information was discounted due to high money market mutual fund volatility following the IL&FS crisis.

The lower risk appetite of foreign investors helped facilitate a 1.8% rupee depreciation versus the US dollar. With trade deficit and balance of payment improvement, a fall in CPI and the subsequent increase in real interest rates as well as normalisation in the real effective exchange rate, we expect the rupee to remain stable with US-China trade negotiations as the only uncertainty.

Outlook

The Fund Managers are constructive on debt markets in 2019.

RBI has been successful with its inflation-targeting monetary policy since its August 2016 inception. This, along with the government’s drive to keep food inflation in check has resulted in lower inflation and significantly higher real yields. We expect a more dovish tone from the Monetary Policy Committee meeting this month and a high likelihood of more than one policy rate cut in the first half of 2019.

The yield curve has steepened with shorter-end yields rallying due to softening in spot inflation and the longer end backing up modestly; partly due to populist concerns ahead of general elections in mid-May 2019 and partly due to the remote possibility of a general election outcome with a left-leaning government at the center. This set of events has provided an opportunity to extend duration.

The loan default by IL&FS has led to widening in spreads for all corporates and non-bank financial companies and created an opportunity for buying offerings of well-run corporates. Improving economic fundamentals bode well for corporate financial health and should prevent corporate spreads from widening further. We expect G-sec yields to rally after the May 2019 elections.