Summary

• Global risk markets pause following a four month rally, as growth disruption risks emerge from geopolitical risks in the Middle East and a fear of the coronavirus outbreak. The former has de-escalated in near terms, but the latter is yet to run its full course.
• Indian markets give mixed signals, with idiosyncratic developments on growth, inflation and the big annual event of Union Budget and policy announcements for the next fiscal year.
• Attractive yields against a backdrop of cresting of headline inflation rates, supportive monetary policy, proactive and conscientious government, drive our positive view on the total return opportunity in Indian debt markets.

Performance

The Fund was up INR 0.69% in January.  A modest 0.03% USD-INR appreciation resulted in a 0.72% USD gain. Fund performance was aided by contraction in credit spreads for Indiabulls Housing Finance, Shriram Transport Finance, Power Grid Corporation, Bajaj Finance, HDFC Bank and high interest accruals in Cholamandalam Investment & Finance Company, SAIL. These events were partially offset by spread expansion in Yes Bank and Mahindra & Mahindra Financial Services. The outcome was a modest beat over the fund’s annual distribution yield at 7.0%. 

Market update

Global risk markets take a breather after an impressive four month rally. This pause can be attributed to two material global developments which brought risk to the fore, firstly, the beginning of January saw unexpected US military intervention in Iran, killing the top Iran military General Qassem Soleimani and spurring thoughts of prolonged conflict and troop deployment. Tensions de-escalated in less than 72 hours with the US clearly stating the action as a one-off case in self-defense and Iran stepping back from conflict escalation despite a public outcry. The second development emerged with the outbreak of the coronavirus. This risk exists as the number of infected patients and the death count continues to rise rapidly. The risk for China’s domestic economy was quickly discounted but global supply chain risks are not quantifiable at this stage and will take a very long time to play out. This resulted in a flat month for the Morgan Stanley Capital International (MSCI) USA Index at 0.1%, -1.3% drawdowns in the MSCI Europe Index, and -4.7% drawdowns in the MSCI Emerging Markets Index. Currency and commodities reflected the same, with the JP Morgan Emerging Market Currency Index and the Rogers International Commodity Index falling by 2.6% and 7.4% respectively. Monetary policies across the globe continue to remain accommodative and will likely stay on course against this backdrop. US ten year treasuries rallied sharply from 1.92% to 1.51% and went below the US Federal Reserve rate at 1.75%; gold rallied 4.7% to its lifetime high.  

Indian markets however gave mixed signals, with idiosyncratic developments and domestic news flows. January started on a conservative note with the IMF and the Central Statistical Office cutting down the outlier growth estimates to align with market expectations. This, combined with a surprising uptick in food inflation, caused CPI inflation to overshoot the RBI’s target band of 2-6%. These developments, however, were quickly discounted on a forward outlook of favorable base effects, tail effects of policy rates cuts and fiscal stimulus in 2019, significant improvement in liquidity conditions over the previous six months, transient nature of food inflation with strong monsoon season and a negative output gap as a better harbinger of core inflation trends. The net effect of these events was a wider and deeper risk appetite with a rally in domestic cyclical sectors like Consumer Discretionary ex Auto, Agriculture oriented companies, Domestic commodities, Infrastructure Developers & Owners in Telecom and Gas Utilities. The outcome was sharp gains in the Nifty MidCap 100 Index and Nifty SmallCap 100 Index of 5.3% and 6.7% respectively against a 1.7% drawdown in Nifty 50 Index. G-Secs yields backed up modestly by 5-10 bps across the maturity curve. Credit spreads were mixed with 5-7 bps expansion in the short end and 2-4 bps contraction in the long end. This resulted in total returns in line with interest income accruals. Indian currency bucked the emerging market losses with a flattish performance for the month up 0.03%, driven by a modest trade deficit contraction and supportive capital flows.

The month ended a day ahead of the year’s most important annual Union Budget event.

A few key takeaways:  

• Accounting prudence was maintained with a forecast of modest tax revenue, 12% and expenditure 13%, increases against a backdrop of 10% nominal GDP growth. The result was tight fiscal management at 3.5% of GDP, a modest increase over FY19 3.4% and improvement over revised FY20 estimates 3.8%. This fiscal management hinges on non-tax revenues from divestment and the telecom sector, which in turn depends on execution efficiency from the top making a slow growth phase more realistic.
• The government continues with economic stimulus for next fiscal year with, a half-step forward on income tax simplification by putting the onus on individuals to save or consume, with a higher tax incentive for consumption and a meaningful 11% and 18% increase in rural schemes and capital expenditure respectively, on top of a 21% and 13% increase respectively in the current fiscal year.
• Budget offers measures to support foreign portfolio flows by removing dividend Distribution Tax which will allow foreign investors to take foreign tax credit in home country. Sovereign wealth funds will be exempt from any tax on dividend, interest or long term capital gains earned on investments in infrastructure. Investment in bond markets encouraged by increasing ownership limits in the corporate Bond market, 9% to 15% and no limit in special category of Government securities.

Outlook

As summarised above and in prior posts, we are encouraged by the multi-pronged, proactive and conscientious approach taken by the government over the last seven months to extinguish risks and seed long term economic growth drivers. The union budget disappointments were largely on the back of high expectations. Ignoring the same, we applaud the prudent fiscal management, higher quality expenditure spending, higher reliance on non-tax revenues in the downturn, steady supply side tax reforms and more transparency in fiscal accounts. This will ensure slow but steady and scalable growth recovery going forward. 

This backdrop against a slow global economic growth offers a higher degree of intervention on the monetary policy front. The first nine months of 2019 was about policy rate cuts. The last four months has seen monetary intervention move toward efficient transmission of liquidity. In the latest RBI policy meeting on February 5, the RBI announced a few material decisions, firstly the introduction of one year and three year Long Term Repo Operations worth Rs 1 trillion at repo rate, with intent to substantially reduce the short term borrowing cost for the commercial and financial sector. Secondly, a five month exemption in cash reserve requirements against incremental lending to autos, residential housing and medium and small scale enterprises. And thirdly a one year extension of one-time restructuring benefits for medium and small scale enterprises and commercial real estate, without downgrading asset classification.

This economic backdrop keeps us constructive on debt markets as both yields and spreads are expected to rally and drive positive returns.