European Central Bank slashing its economic growth forecast and increasing optimism over US-China trade negotiations.

Summary

• Unexpected increases in geo-political tensions and prompt actions by PM Narendra Modi have spurred nationalistic sentiments, signaling a possible turning point for the general election. This event also marked the turning point for flows from Foreign Portfolio Investors (FPI).
• Dovish European Central Bank (ECB) and US Federal Reserve (the Fed) signals provided increasing odds of a successful conclusion of US-China trade talks and strong FPI flows have provided temporary respite for the RBI to tackle the liquidity situation head-on and improve the monetary policy transmission.
• The Fund remains constructive on debt markets in 2019. Benign inflation expectations and their implication for high real rates, a steep yield curve and high-grade credit spreads drive our positive view on total return opportunity in debt markets.

Market update

February ended on a hawkish note, with concerns of fiscal slippage driven by a populist narrative in the interim Union Budget, increasing concerns on growth and weaker tax collections due to tighter liquidity conditions and risk of escalation in geo-political tensions with Pakistan.

March saw signs of the reversal of these fears. It started with the polls registering approval of the leadership demonstrated by PM Modi following a terrorist attack within India. With elections the biggest risk for Foreign Portfolio Investors, this event is seen as turning a point and FPI inflows swelled. Globally, this coincided with the ECB slashing its economic growth forecast and increasing optimism over US-China trade negotiations.

Besides fiscal concern, higher borrowings by government owned enterprises, higher currency in circulation needs in election season, high incremental credit-to deposit ratios and the tail effect of higher funding costs for non-banking financial companies (NBFC) post default by IL&FS have been influencing tight liquidity conditions. FPI flows came as a much wanted relief. Fed guidance to put rate hikes on hold for 2019 gave the RBI license to specifically target the monetary policy transmission head-on. RBI went a step forward, using these capital flows to infuse liquidity through FX swaps, maturing in 3 years. The first tranche of US$5bn was executed in late March and a second one is in the pipeline for end-April.  

The RBI has maintained the aggression with a second policy rate cut of 25 bps on April 4. Besides policy rate cuts on expected lines, the RBI has announced additional liquidity management tools to weigh on bonds:  (1) phased increase in Facility to Avail Liquidity for Liquidity Coverage Ratio (FALLCR) by 2% of Net Demand and Time Liabilities (NDTL);  (2) a committee to assess the state of Housing Finance Securitization market given its dominant leadership in lending by NBFCs and cascading impact on sub-prime borrowers; (3) permitting G-sec trading through International Central Securities Depositories to attract higher FPI interests.

The G-secs market responded quickly and the benchmark 10-year yield on government bonds rallied by 13 bps from 7.69% to 7.56% (old series) and a much smaller 6 bps from 7.41% to 7.35% (new series). The yield curve flattened modestly, with spreads between 10-year Gsec and 1-year Gsec easing from 111 bps to 103 bps but this spread remains at the higher end of historic band of 50-75 bps. Credit spreads tightened marginally on a falling yield curve, with spreads on 10-year AAA and AA corporate bonds tightening by 8 bps and 7 bps respectively

The current spreads for 10-year paper for AAA, AA, A rated corporate stand at 102 bps, 154 bps, 285 bps respectively, the higher end of the historic band of 40-70 bps, 80-120 bps, 200-250 bps respectively. Credit spreads for NBFCs of similar rating and duration is incrementally wider by 23 bps. 

The flows by both FPI and domestic investors do indicate a first vote of confidence on the RBI’s actions. FPIs bought debt worth US$2.2bn after two consecutive months of outflows. Domestic Mutual Fund flows remained strong for the third straight month with US$11.2bn of inflows.

Strong FPI buying in both bond and equity markets, relative stability in oil prices and optimism on US-China trade negotiations led to 2.67% appreciation in INR in March. RBI actions to infuse liquidity through FX swaps are likely to leave the Indian rupee range bound in the near term

Performance

In March, the Fund’s NAV gained 1.08% in Indian rupee terms, supported by the rally in G-secs and marginal tightening in credit spreads.  A strong rupee appreciation (up 2.67%) further augmented returns to result in a 3.75% gain in US dollar terms. The Fund Managers have simplified the Fund structure in March, which negatively impacted fund performance by a few basis points in March, but which we believe will be more than compensated going forward with simpler fund flows and administration cost savings. The Fund has used this opportunity to extend duration in the Fund’s gilt book. The Fund’s reduced cash levels, currently 3.9% of AUM, reflect our constructive view on debt markets.

Outlook

The Fund Managers remain constructive on debt markets in 2019.

The RBI’s success with the inflation-targeting monetary policy and the 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 pressure from tighter liquidity, creating significant room for policy rate cuts. We have already seen two policy-rate cuts this year and we see high odds for another cut at the June meeting.

The RBI is in a sweet spot to use the strong foreign flows and global growth slowdown concerns to address the monetary policy transmission. We are starting to see those signs of aggression and expect the yield curve to flatten from these levels. 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 driven by confidence in a stable, 5-year government regime. This scenario will positively influence credit spreads this fiscal year.

Countering this excitement are 2 risks – (1) Skymet weather is guiding for a difficult monsoon season, impacted by a devolving El Nino effect. This is the smallest share of GDP but it accounts for a sizeable share of population. Given stagnant farm incomes over past 2-3 years, this sector is garnering attention with farm loan waivers, farm support income or universal basic income (2) Government need to rework its privatization model with a focus on improved competitive position and corporate governance. Continuously supporting these via their own finances is crowding out development funding.