Summary

• Heavy lifting by RBI and government backstops had a mixed impact on debt markets with a steepening in the yield curve led by a rally in the short end and a modest back up in the long end.
• However, these policy actions were not strong enough to protect from a steep currency depreciation, impacted by fears of a currency war and a global growth slowdown. The INR remains somewhat hostage to a weak Chinese currency, given India’s trade deficit with China.
• However, high real rates, a steep yield curve and high-grade credit spreads against a backdrop of benign inflation expectations continue to drive our positive view on the total return opportunity in Indian debt markets.

From a policy perspective, August kicked off with the RBI unexpectedly cutting by 35bps (rather than a more conventional 25 or 50bps) while maintaining an ‘accommodative’ stance. In addition, the RBI also lowered risk weights on consumer credit including personal loans from 125% to 100% (excluding credit card receivables), raised the bank’s exposure limit to a single NBFC from 10% to 20% of Tier-I capital of the bank and allowed bank lending to registered NBFCs (other than MFIs). Specifically for on-lending to agriculture (up to INR1mn) and micro, small enterprises and housing (up to INR2mn) per borrower to be classified as priority sector lending.

The central government followed with a series of market-friendly actions:

• removal of the higher surcharge on capital gains tax for FPIs
• faster repayment of pending GST refunds to small and medium enterprises
• additional liquidity support of INR200bn to Housing Finance Companies
• faster repayment of arbitration funds in contractual disputes between government/public sector enterprises and private entities and the immediate recapitalization of government owned (PSU) banks by INR700bn
• launch of repo/external benchmark-linked interest rate products.

These actions were quickly followed by an announcement of the merger of ten PSU banks into four, followed up by a capital infusion of INR552bn into these banks, empowering their board and management.

However, the government has not yet provided any fiscal stimulus either through broad-based tax cuts or industry-specific GST rate cuts (demanded by several industries) in order to revive demand. The hesitation likely indicates the constraint of limited fiscal capacity in the context of faltering tax revenues, in a slowing economy.

Other economic headlines flows were light – with July manufacturing PMI at 52.5 (previous month at 52.1), IIP at 2.0% (3.1%), CPI at 3.15% (3.18%), WPI at 1.8% (2.0%), trade deficit at $13.4 bn ($15.3 bn) and a smart recovery in monsoon with heavy rainfall in the last 2 months resulting in the cumulative rainfall being the long term average. On a spatial distribution, out of the 36 sub-divisions across India, 22 have received normal rainfall, and eight have received excess rainfall.

This overall policy backdrop has led to a steepening in yield curve with 2-year government securities (G-secs) rallying by 26 bps from 6.04% to 5.78% and 10-year G-Secs backing up by 19 bps from 6.37% to 6.56%. With yields tightening, credit spreads also enjoyed a modest rally; spreads on 2-year AAA and AA rated corporates softened from 115/182 bps to 107/164 bps respectively. Spreads on 5-year AAA and AA rated corporates softened from 116/178 bps to 106/170 bps respectively.

However, while policy actions in India were helpful for bond markets, its equity markets remain stressed by the global markets turmoil. The US Fed’s modest 25 bps cut led to a further inversion in the US Treasury yield curve, signaling expectations of a slowdown. Moreover, trade tensions between the US and China escalated dramatically, resulting in a sell-off in global equity markets (MSCI USA index down 2.0%, MSCI Europe down 1.7%, MSCI Japan down 3.3% and MSCI Emerging Market down 5.1%). Commodities sold off as well – Brent, LME Aluminum and Copper were down 7.3%, 2.7% and 4.2% respectively. In contrast, Gold and Silver rallied by 7.5% and 13.0%, reflecting haven demand. FPIs sold Indian equities heavily for the second consecutive month at $2.3bn and bought Indian debt for the fourth consecutive month at $1.8bn. A steep sell-off in EM currencies (JPM EM Currency Index was down -3.96%) led by an even steeper loss in the Renminbi sparked fears of currency wars and also dragged the INR/USD down with -3.67% drop.

Performance

The Fund gained 0.11% in INR terms. However a steep -3.67% depreciation in INR-USD, resulted in a draw of 3.56% in USD terms. G-sec performance was mixed this month, as highlighted above, with modest gains on the short end and a modest loss on the long end. The performance was essentially led by appreciation in corporate bonds excluding NBFCs credit, namely Export Import Bank of India, Steel Authority of India, Power Grid Corporation, HDFC bank and Yes Bank. NBFC credit continued to drag the performance of the Fund and this month was specifically impacted by a loss in Dewan Housing Finance and Indiabulls Housing Finance. The performance of this space will be governed by effective adaptation of proposed resolution plan and alignment on asset-liability mismatch for Dewan Housing Finance over next few months.

Outlook

As discussed previously, India’s growth has been slowed down by a mix of many things rather than a single dominant item – termed as ‘a smorgasbord recession’ by Paul Krugman. The seeds of this slowdown essentially were sown during the formalization of its economy which started with demonetization in late 2016, gathered pace with GST implementation in July 2017, and has accelerated with the mid-2018 NBFC liquidity crisis. Concurrently, 2 consecutive tough monsoons have adversely impacted India’s agri-economy and the weak demand and pricing of residential real estate has impacted wealth creation, consumer confidence and technological disruptions in telecom and climate change on power utilities have also had meaningful consequences. Importantly, global risk appetite and trade growth is hostage to the US-China trade dispute and nationalism, with negative implications for India’s currency and export growth.

These list of problems collectively sound ominous. However, this is both a threat as well as an opportunity. The threat is that the stresses lack a clear narrative and therefore runs a risk of half-hearted, stop-start intervention by a government which believes in fiscal discipline and the role of private markets. This explains the slow and steady downtick in growth rates, which, when it reverses, would likely recover gradually, rather than experience a sharp snap-back.

Howeverthis backdrop will keep inflation under check and keep interest rates lower for longer. The current inflation / growth outlook support further sharp policy rate cuts, offering the potential for a large rally in long duration paper, resulting in low double digit total return opportunity in G-Secs. The Fund has roughly a third of its book in G-Secs and most of it in long duration to capitalise on this opportunity. While this month saw some relief on credit spreads, they remain close to their widest levels and likely to normalise with sharper and larger focus on growth revival by monetary, fiscal and regulatory bodies of government. We feel confident that the Fund is poised to take advantage of these benign bond market conditions in the coming months.