Summary

• Union budget and growth pangs spur treasuries, jar equities and credit markets, but leave currency unruffled.
• Cumulative monetary policy rate cut at 110bps overshoots our start of the year expectations of 100bps. However favorable inflation and weak growth conditions drive up our expectations further to a cumulative 150bps rate cut.
• Credit spreads are possibly at their widest levels and likely to normalise with sharper and larger focus on growth revival by monetary, fiscal and regulatory bodies of government

July started on a bullish note with great hopes about the first Union Budget from Modi government 2.0 and the first budget by newly appointed Finance Minister Nirmala Sitharaman. The budget successfully addressed the biggest concern in the mind of investors, the fiscal deficit, by maintaining a tight leash on expenditures. The stability in the government’s net borrowing intentions was further supplemented by its intent to raise funds through US dollar-denominated government securities (G-secs) for the first time in its history. This spoke volumes on India’s confidence in its macro-stability and a goal to diversify investor base for its debt. These steps sparked a steep rally in G-secs by 30-50 bps, with the yield on 10-year G-Secs rallying from 7.07% to 6.78% and 5-year G-Secs rallying from 6.88% to 6.37%.

Conversely, the fiscal discipline triggered concerns about growth and resulted in a sharp sell-off in equity markets; with 5.7%/9.8%/10.9% loss in INR terms for NIFTY 50, NIFTY Midcap 100 and NIFTY Small cap 100 respectively, making them the worst performing markets among the larger economies. The government’s decision to raise excise duties on diesel and gasoline by 2 Indian rupee per litre was sufficient to wipe out the benefit of 50-75 bps decline in interest rates on cost of ownership of two-wheelers and four-wheelers. The increase in customs duty on gold from 10% to 12.5% was purportedly seen a as sign of encouragement by revaluing the domestic price of gold stock upwards. The increase in tax surcharge on high income earning individuals with more than INR 20mn was ostensibly seen as a sign of denting demand for high end real estate; a further drag on struggling real estate developers and housing finance companies. And lastly, a government proposal for increasing minimum public holdings from 25% to 35% is an earnest move to boost FPI flows in the long term. However with markets down, this was seen as a case of excess paper supply worth US$30bn in medium term, crowding away money from secondary markets and the new stock offerings by incumbents and unlisted companies.

The budget tried hard to address the tight liquidity concerns with a double pronged approach – (1) INR 700bn recapitalization plan for government owned banks and (2) liquidity boost worth INR 1tn to NBFCs by providing support for banks to buy high-rated pooled assets of financially sound NBFCs with one-time 6 months partial credit guarantee for the first loss up to 10%. Credit markets however ignored these measures and spreads widened further to a new high in Modi’s government of 5+ years. Spreads on 5-year AAA and AA rated corporates widened from 114/169 bps to 116/178 bps respectively. More importantly, spreads for NBFCs, which provide 18% of credit, are wider by ~22 bps. Spreads on 5-year AAA and AA rated NBFC widened by from 134/196 bps to 138/201 respectively.

Economic headlines flows were light, with June manufacturing PMI at 52.1 (previous month at 51.7), June IIP at 3.1% (previous month at 3.4%), June CPI at 3.2% (previous month at 3.1%), June WPI at 2.0% (previous month at 2.5%), May trade deficit at $15.3 bn (previous month at $15.4 bn) and slow and steady recovery in monsoon with heavy rainfall in July resulting to deficit shrinking to 9.9% below long term average (previous month at 28.1% deficit). However the Indian markets were constantly jolted by payment delays/defaults by large companies including Dewan Housing Finance, the entire Anil Ambani group of companies and a few SMEs including Sintex, Cox & Kings, Jain Irrigation, Eros International, Mcleod Russell and Mercator Lines.

FPIs turned sellers this month and sold equities worth US$1.7bn in cash markets and US$0.9bn in futures market. FPIs continued to buy debt for the second consecutive month, supported by dovish central banks globally and bought debt worth US$1.4 bn. Marginal net FPI outflows and softer crude prices with dated Brent at US$65.2/bbl (previous month at $66.6/bbl), helped INR clock a modest 0.33% appreciation against US dollar.

Performance

The Fund gained 2.11% in INR terms. This performance was supplemented by 0.35% appreciation in INR-US dollar, resulting in 2.47% gain in US dollar terms. This feat was led by holding longer duration G-Secs and a high coupon income on medium duration corporate bonds. The Fund’s holding in Dewan was stable as the company has guided on no principal haircuts to any creditors, but a potential moratorium on repayments. The latter will remain an issue and cap any upside in near term. However, further downside is also restricted and subject to effective adaptation of the proposed resolution plan and alignment on asset-liability mismatch over the next few months.

Outlook

We started the year with expectations of a modest global growth slowdown resulting in dovish global monetary policy, stable crude prices with tight supply on geo-political risks offset by growth slowdown led demand cuts, stable currency markets with no big global disruptions and a high rhetoric, but steady negotiation and a definite resolution on US-China trade talks. On the Indian front we expected a favorable election outcome with BJP forming a government with a wider coalition support from regional parties in worst case, dovish monetary policy given high real yields against a flagging growth, and an effective monetary policy transmission from banks to lenders under a stable and favorable ruling party, eventuallyto revival in animal spirts on consumption and investments with a year’s lag marking a turning point on growth.

Fast forward 7 months, Reserve Bank of India (RBI) has done 110bps of policy rate cuts over four meetings with the latest round of cut of 35bps on August 7. The RBI has revised down growth expectations with risks to downside in near term - 5.8-6.6% in 1HFY20 (6.4-6.7% earlier), 7.3-7.5% in 2HFY20 (7.2-7.5% earlier). On inflation, RBI expects upside risks to food inflation on weak and uneven rainfall distribution offset by softening in core inflation and inflation expectations. RBI expects 2QFY20 CPI inflation at 3.1% (3.0-3.1% for 1HFY20 earlier) and 2HFY20 inflation at 3.5-3.7% (3.4-3.7% earlier). RBI maintains its stance as ‘accommodative’ with growth concerns as the highest priority and little to worry on inflation. This has increased the odds for another 40 bps rate cut this year (cumulative 150 bps as against expectation of cumulative 100 bps rate cut at the start of the year). We also recognise the supportive external environment with dovish global central banks and weak supply side inflationary forces

Credit spreads have widened by ~15 bps and are at their widest in the past 5+ years. Consistent with the RBI’s end goals, credit spreads have to start turning a corner sooner than later, else we run the risk of a negative cycle of reflexivity from credit and equity markets spoiling the equilibrium. This might imply a partial rollback in tax surcharge on capital gains and a modest giveaway on fiscal management with a limited time period fiscal stimulus for consumer discretionary goods, namely autos and real estate. The government had also restrained expenditure in quarter pre-election and election quarter (4QFY19 and 1QFY20). With meaningful 8% share in country’s GDP, we expect a rapid normalisation of expenditure trends once the monsoon season is behind us. Lastly, we expect an accelerated execution of liquidity infusion in government owned banks and NBFC as announced in the Union Budget. The Fund already has a high exposure to corporate bonds and should see the benefits of that exposure over next 12 months.