Summary

• The Indian government intervenes with the biggest tax reform of the past 28 years’ and the RBI is supportive with an additional 25 bp cut in early October. The stimulus drives a modest rally in currency and equities.
• Growth slowdown, fiscal intervention and dovish monetary policy have a mixed impact on debt markets, with a further steepening in the yield curve - the short end rallies and the long end backs up modestly.
• High real rates and credit spreads paired with benign inflation expectations and tax reforms supporting corporate profits drive our positive view on the total return opportunity in the Indian debt markets.

Market update

India had eschewed fiscal intervention until September however, mounting growth concerns and eroding business sentiment forced the Modi government to take action, leading to a decisive supply side fiscal stimulus in September. India launched the biggest corporate tax reform in the last 28 years’ of economic liberalisation, in the form of a reduction in corporate tax rate from 34.9% to 25.2%. Additionally, to spur capital formation, a special 17% rate was set for new companies starting new manufacturing facilities before March 2023.

The stimulus comes with an estimated revenue loss of Rs1.45 trillion (0.7% of GDP) on a full-year basis. Some exemptions related to measures in free trade zones or SEZs estimated to be worth Rs1.1 trillion, could provide an offset to revenue loss. The revenue shortfall will be mitigated by extra dividends from the RBI, expenditure cuts and aggressive mobilisation of non-debt capital receipts. These steps are likely able to mitigate the deficit, hence the 2HFY20 borrowing program remains unchanged.

These series of interventions – targeted toward injecting liquidity - started on the 23 August 2019, with the rollback of a higher surcharge on capital gains tax for FPIs, speedier repayment of pending tax refunds to MSME, additional liquidity support to Housing Finance Companies, partial repayment of arbitration funds in contractual disputes between government enterprises and private entities and the launch of repo/external benchmark-linked interest rate products.

On 30 August 2019, the government announced the mega merger of ten public banks into four, followed with a capital infusion of Rs552 bn along with additional management and board powers. 

On 13 September 2019, several measures were taken to aid the real estate sector including relaxed external commercial borrowing norms for homes built under select schemes, lower interest costs for housing loans to government employees and establishing a fund to extend credit to select affordable/mid-income projects.

Globally, oil markets saw a big spike, post drone attacks resulting in the largest-ever disruption of crude production at 5.7 mn b/d of current crude production in Saudi Arabia.  This attack was promptly addressed with large inventories, strategic reserves and a partial restoration of Saudi production. Sentiment quickly improved with checks on geopolitical tensions between Iran and Saudi Arabia leading to a full reversal of gains. Fed rate cuts and guidance were in-line and a non-event. US-China trade news was benign and offered relief to global markets.

Debt markets underperformed globally as capital rotated into equities. There was no scheduled meeting for India’s monetary policy committee in September. However, the 4 October 2019 policy meeting saw the RBI deliver its fifth consecutive policy rate cut, lowering the rate from 6.5% at start of the year to 5.15% currently. The policy statement was dovish, with the MPC stressing the need to ‘continue with an accommodative stance as long as it is necessary to revive growth’. The MPC revised down its FY2020 growth forecasts from 6.9% to 6.1%, but maintained its 2HFY20 inflation outlook at 3.5-3.7%.

Weak monetary transmission and fiscal concerns meant a further curve steepening with 10-year G-secs backing up from 6.56% to 6.70%. Corporate tax cuts will help corporate profitability and aided tightening AAA/AA rated credit spreads by 13 bps for 5-year bonds. However asset quality concerns restrained NBFCs credit spreads tightening to merely 6 bps. Foreign Portfolio Investors flows reflected these trends with $1.0 bn inflow into equities, and $0.2 bn outflow from debt. Overall net strong foreign flows and stable oil prices drove 0.76% USD-INR appreciation, despite a 0.23% stronger dollar US trade weighted dollar.   

Performance

The Fund gained 0.42% in USD terms, supported by a 0.76% appreciation in USD-INR. Outperformers included non-financial companies and high interest accruals in NBFC’s. A steepening in the yield curve impacted fund performance, primarily on the longer maturity G-Secs and other longer maturity bonds. A small holding in Dewan Housing Finance continues to be a drag on performance, but we expect a reversal in the next few months.  

Outlook

India’s growth engine has been slowed by a mix of many small issues rather than a dominant item and this had increased the risk of half-hearted government intervention. That said, after the steps taken recently, we are encouraged by the multi-pronged, but fiscally prudent governmental measures discussed above.

We look forward to the continuation of reform momentum including large scale divestment of government owned entities, monetization of non-strategic stakes held in private enterprises and  other assets, review of existing rules in order to encourage greater private sector investment in basic infrastructure sectors, introduction of a bill for scrapping 15+ year old vehicles (helping both growth and pollution control), and agri-sector reforms to help the viability of small land farming.

These measures are just a start, the recovery will be gradual. The near term outlook is likely clouded by subdued 2QFY20 earnings and weak demand and pricing of residential real estate. Moreover, the NBFC asset quality crisis is creating second order liquidity issues and disrupting the sales cycle across the consumption space.    

The inflation-growth dynamic implies lower interest rates for longer. A steep yield curve offers the potential for a broader long duration rally, resulting in a double-digit debt market opportunity. The fund has roughly a third of its book in G-Secs and most of it in long duration to capitalise on this opportunity. September saw some relief on credit spreads, but they remain close to their widest levels and are likely to normalise gradually, with higher 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.