This article, written by Maneesh Dangi, Co-Chief Investment Officer, Birla Sun Life AMC, is part of Morningstar's "Perspectives" series, which is a series of articles written by third-party contributors. Dangi spearheads the fund house’s fixed-income practice in addition to managing his signature funds. The views contained herein are those of the author(s) and not necessarily those of Morningstar. If you are interested in Morningstar featuring your content on our website, please find more information here.
There has been an interesting disconnect between the global and Indian business cycle over the last two years. While the rest of the world, particularly the western central bankers have steadfastly focussed on reviving growth since 2011, India has been caught in a strange dilemma between high inflation and elevated CAD on one hand and a pretty significant growth slowdown on the other. No wonder our central bank has adopted a cautious and calibrated approach over the last 18 months.
Typically, slowdown is the best medicine for all macro risks, as economies are smart beings, which tend to correct excesses or imbalances automatically. Growth slowdown is generally the automatic response to high inflation or high CAD.
Central bankers typically pre-empt high inflation or CAD and try to moderate growth by making money pricier. The RBI did the same to tackle these risks, though many argue that the response was delayed and slow.
As India struggled with this non-textbook macro-economic environment in mid 2012, we spotted an opportunity for a significant bond rally in India and, in August 2012, came out with our 7.5% prediction on the 10-year bond.
Now that we have travelled by more than 60 basis points since we wrote the note, and are in striking distance from 7.5%, it’s appropriate to look beyond. Our extensive analysis intends to mark the beginning of the next big wave of bond rally in India. We hereby put forward our case of 10-year G-sec to breach 7% levels by the conclusion of the current rate cycle.
Our projection is based on a detailed look at five pillars of analysis: 1) the growth-inflation dynamic 2) demand-supply technicals 3) liquidity situation 4) credit segment and 5) security-specific factors.
While the consensus on FY13 GDP stood steady at 6% when we released our last note, we were amongst the very few looking at a dismal 5-5.5% rate of growth. As unfortunate as it could be, turns out we were right and hence, we may end up witnessing a decade-low rate of growth of 5% for FY13.
Looking forward, we expect FY14 GDP to remain low at ~5.5% (with a downside bias). The continued slowdown over the last 24 months is likely to remain protracted in the absence of any turnaround in the current sluggish investment scenario, which in our view is difficult to foresee in this fiscal.
While growth is expected to remain subdued, the silver lining in India’s macro story would be offered by further decline in headline inflation.
The low-growth-high-inflation scenario has haunted us for quite some time. But as it now looks, it was in fact only a matter of time for inflation to follow the declining trend in growth, albeit, with a lag. For FY14, we expect WPI to moderate to ~5.5% from 7.4% in FY13.
Once the inflation devil is tamed, the next villain threatening the macroeconomic stability is the ballooning CAD. Just like inflation, CAD was another counter-intuitive part of the Indian macro story whereby, despite continuous growth slowdown, our CAD worsened from 4.2% in FY12 to ~5% in FY13.
But, looking forward into FY14, we expect CAD to moderate to 3.5-4% largely due to a moderation in our net oil imports, some improvement in the non-oil, non-gold trade balance and rupee remaining stable at current levels.
A macroeconomic scenario characterized by low growth, moderating inflation and receding CAD should eventually pave way for RBI to become more responsive to the current growth slowdown.
In order to arrest the slowdown in growth momentum while risks of inflation re-emergence remain under check, we expect RBI to cut repo rate by another ~75 bps in this fiscal.
To top it all, we expect that with a change in guard, RBI’s view on liquidity and rates is likely to become more benign and as we bypass the inflation and CAD risks, the entire thesis of maintaining liquidity deficit when in an anti-inflationary stance would undergo an ideological change.
Thus, we expect the RBI to leverage multiple tools to ease liquidity such as mopping up USD flows, OMOs and CRR cuts through FY14 and FY15. All this should translate into an additional effective easing of ~175 bps in the current rate cycle, where we expect middle of the corridor to become the operative rate.
As a result we expect terminal repo rate to fall 6% by the end of this cycle, we believe 10-year G-sec will rally from the current 7.7-7.8% levels to inside of 7% within one year.
Moreover, we believe that there is a good case for SDL and corporate bond spreads to tighten further going into FY14 as high quality assets will remain well bid. We see terminal spreads for SDL’s at 25bps and AAA PSU’s at 50bps.
Will the low-rate regime be durable? I think the answer to this lies in the state of corporate balance sheets and increased stress in banks’ books. RBI had ensured a low rate regime during 2001-03 to stimulate investment from corporate and heal the balance sheets of banks which came under severe pressure due to protracted slowdown.
In the past of couple of years, there has been a similar leverage increase in corporate balance sheets and consequent stress which is manifested in elevated bank delinquencies. All this strengthens the durability of the rate reduction cycle.
But of course, like any other proposition, our hypothesis too is subject to some risks. A key risk that may alter our view is the uncertain political scenario that may result in early general elections. Any such preponement of election may force the RBI to halt the rate easing cycle as the government recalibrates its fiscal framework and its response to critical policy concerns.
Nonetheless, if everything pans out as we have envisaged, then I would like to argue that we are in the process of setting up the stage for a brand new business cycle, as important condition precedents (low rates, low inflation, substantial cumulative output gap and awakened government) for a sustained economic recovery are falling into place.