Calm amidst market volatility

Nobody can say that the last one year has been uneventful—right from the doomsday prophesiers on Brexit, Hillary pilloried by Trump or now demonisation of Rs 500 and Rs 2,000 notes. It is interesting to note that whatever maybe the buzzword, the outcome of the event has been unexpected. Result has been a much higher volatility in the markets as the markets do not like too many uncertainties. However, to everyone’s surprise the market has had the gumption to digest the volatility emanating out of these events.

On the Indian fixed income markets, the year has been quite an eventful one; look at the ten-year government bond-yield from start of the year which was at 7.73 per cent and till June 2016, the ten-year just moved down by 23 basis points the bulk of which came after Dr. Raghuram Rajan decided to quit and the new regime started with a rate cut. In September 2016, the yield was at 6.73 per cent and end of November traded at 6.23 per cent. This is a whopping 150 basis points downward since the start of the year. This move has been in contrast to the rising yields on emerging market debt which is in response to the surprise win of Donald Trump as President of the United States of America. The yield softening trend is counterintuitive to the global bond yield move and any hasty lowering of repo rate can result in reversal later.

The stance on liquidity from RBI was to move from forex market to bond markets to reduce liquidity deficit to neutral from almost 3 per cent of Net Demand and Time Liabilities (NDTL). RBI conducted open market operation (OMO) purchases worth about `1.1 trillion which had a salutary effect on the long bond yields and banks getting an option to book profits on their held to maturity portfolios.

On the inflation front, the CPI has shown a declining trend largely on a benign base and muted energy prices, the core inflation remained stubborn and the pulses inflation has started retreating which added about 1 per cent to the headline number. We believe that the trend on inflation will be stable to declining while the bugbear would be the weakening rupee and higher commodity prices which will feed into retail inflation.

On the fiscal front the government has clocked about 79 per cent of the budgeted fiscal target from April to October 2016, revenue targets are at about 50 per cent. We have seen this trend in earlier years as well and we expect the government to meet its FY17 fiscal deficit target of 3.50 per cent of GDP either by raising revenues through asset sales or cutting expenditure. The current account has been around 1 per cent of GDP till June 2016. We have also witnessed the forex reserves increase from $349 billion to $367 billion in spite of the FCNR redemptions to the tune of $22 billion.

Till now we have seen a relative calm in Indian fixed income markets and the currency markets and Indian rupee is ranked 17th this calendar year out of the 24 emerging market currencies having lost only 3 per cent since start of the year. An investor investing in US dollar in an Indian ten-year government bond would have earned an annualised return of 6.2 per cent adjusted for currency assuming no hedging. This is far superior to any developed market sovereign bond return.

Demonetisation of the high denomination currency notes of Rs 500 and Rs 1000 have enhanced the liquidity with the banks as well as caused the money market rates to decline significantly by about 40 to 50 basis points. The government bond also declined by about 30 to 40 basis points due to expectation of money moving to formal economy from informal, better tax compliance and due to immediate impact on growth, increasing chances of deflationary impact on prices lowering inflation, giving room to RBI for cutting rates further. In this backdrop, the moot question is what the opportunities are for a fixed income investor— can one still invest in longer maturity fixed income funds or accrual products will be more attractive?

In the current RBI Monetary Policy Committee framework, the explicit weight given to both inflation and growth is itself dovish and the range of inflation from 2 per cent to 6 per cent is a wide one. The central bank has also acknowledged that the real rate of return is a range estimate instead of a point estimate and currently stands at 1.25 per cent to 1.50 per cent, from this we can infer that the repo rate can be 5.25 per cent to 5.75 per cent if the inflation ranges around 4 per cent to 4.50 per cent. The current ten-year Government Securities (G-Sec) benchmark stands at 6.23 per cent which is below the current repo rate which means from a steady state level, the market is already discounting 50 basis points repo rate cut meaning the market is already discounting an inflation of 4.50 per cent. Looking at this in context with the global bond yields, Indian bonds are asynchronous and the likelihood of them falling in line is high as the monies from FPIs gets pulled out for deployment in developed markets.

On the global front, there is very little known and the unknown can make the market appear rather unsettled or even uncertain. We are yet to see Trump administration policies taking shape and their impact on the US economy while with Brexit it is very likely that we may see several other countries follow suit.

In general, the markets are expecting the global economy to progress as the US economy moves ahead, improving smaller economies along with it. This can mean inflationary pressures in form of commodity prices. A larger global population and lesser land to cultivate along with the inclement weather patterns can mean higher food prices for some categories.

We envisage that with volatility being the cornerstone in the coming year and looking at the risk reward payoff, the fixed income investor is better off in short- to medium-term funds with an accrual focus. The dynamic bond funds which are mandated to ride the volatility of the markets are also suitable for investors.

What counts

• Indian rupee is ranked 17th this calendar year out of the 24 emerging market currencies.
• Current ten-year G-Sec benchmark stands at 6.23 per cent which is below the current repo rate.
• Indian bonds are asynchronous and the likelihood of them falling in line is high.

Dwijendra Srivastava is CIO—Debt, Sundaram Mutual Fund

olmdesk@outlookindia.com