Just a couple of months back, with inflation trending down, the central bank easing made a perfect case for a bond bull story. But in this story, two things are critical?fiscal consolidation by the government and containment of current account deficit. Does the bond bull story still hold?
Post-Ben Bernanke?s press conference where he sounded hawkish about the economy which meant tapering of the quantitative easing cycle and that too sooner than most estimates; guidance from Bernanke indicated the easing cycle to end by mid-2014. This spooked the markets globally causing a sell off across all asset classes?the common factor being easy liquidity.
The countries most affected were the ones with large current account deficit and dependent on funding from portfolio flows. From Ben Bernanke?s press conference till July 8, Indian rupee has been one of the worst performers in a pack of 24 emerging market countries where it ranked 16th. A combination of weak macros viz. low growth (sub-5% run continues), gaping current account (4.8% of GDP-double of which India can sustain), poor quality of expenditure (low investment-to-GDP ratio), fast depleting import cover (around six months cover), alarmingly high short-term external debt of $176 billion (maturing within one year) have exacerbated the rupee fall.
The central bank is in a catch 22 situation—low growth bodes for easy monetary policy, and poor external sector situation warrants a tighter one. We believe that the central bank has to support growth at this stage and refrain from any reversal on the policy stance?the portfolio flows also buttress this fact, India has more equity flows than fixed income flows, which indicates India does not have too much of arbitrage money.
The government?s move on policy reforms is tantamount to a better economic picture and any slack there can result in macro economic variables worsening from current levels. The current political landscape may not allow for any significant progress on the policy reforms, but any further deterioration on the fiscal front can raise inflationary expectations and weaken the rupee, causing the current account to widen further.
Self-balancing factors can come into play, as the rupee weakening can make Indian exports attractive while the demand for imported articles fall. The imposition of duties on gold and a host of restrictions set by the RBI on banks to limit gold sales can impact the current account favourably. Foreign investors can take advantage of their stronger currencies to increase their stakes in the Indian companies.
If we look at the global factors, barring the United States no other developed economy looks promising?Japan?s new-found aggression to fight deflation is marred with a debt-to-GDP ratio of over 240% and an ageing population, the eurozone has Germany as the performing economy, with the onus of subsidising the weaker countries in the zone and China is in a slow lane with resurging inflation. The consumption cycle to resume will take some time and we do not expect global commodity prices rising at a fast clip. The shale gas revolution in the US means a cap on crude prices.
Inflation in India for quite some time has been driven by the profligate ways of the government?the obstinacy to spend on populist schemes destroys avenues to productive spends which can alleviate inflationary expectation in the medium-to-long run. The latest addition to the populist schemes is the food security bill?a potent tonic to make the young demographics non-productive; a person at the bottom of the pyramid needs two square meals with shelter; if one gets 100 days of employment and a guarantee of food grains her ambition to grow will get destroyed?less migration, higher wage bills, etc. This socialist model is a sure shot formula for lower growth.
Inflationary phenomenon for now is not demand-driven; it is more to do with the consumption pattern and current policies of the government which are creating artificial price levels and bottlenecks in supply.
Now looking at the place where it all began, the United States; the recovery in the US started from the mortgage market and increased construction activity–in the last couple of months the 30-year mortgage rate has increased from 3.68% to 4.57%, now almost 100 basis points increase, this can lower demand for new homes as well as employment in the construction industry. So the likelihood of a complete wind-up of the asset purchase programme may get delayed from the indicated time line; even the Federal Reserve has been vocal about the fact that wind-down or step-up of asset purchases will depend on the incoming data.
We believe that volatility on rates is likely to remain high as the uncertainties on the political, fiscal, and external fronts remain high?the rupee volatility remains the key to bond market stability. We do not see the central bank raising interest rates in the near-term as despite the central bank cutting rates by 125 basis points the transmission in base rates has been just 30 to 60 basis points, which means the interest rates have not fallen despite the signalling a move down. Additionally, we believe that the growth woes are likely to keep the central bank in a pause mode. The liquidity cycle will be affected by government spending, credit-deposit ratio and foreign capital flows (outflows).
Looking at these factors we believe that an investor, in consultation with her financial advisor, depending on her investment horizon and risk appetite, can look to allocate funds to duration buckets for the next six to nine months. Cash funds are likely to under-perform the duration funds in the next six to nine months contingent on the system liquidity conditions.
Dwijendra Srivastava
The author is head of fixed
income, Sundaram Mutual Funds
