Dhaval Kapadia, Director, Portfolio Strategist, Morningstar Investment Adviser, analyses the impact of RBI's rate hike on Morningstar Model Portfolios.
In another pre-emptive move, RBI hiked the repo rate by 25 bps while retaining its neutral monetary policy stance. This was broadly in line with market expectations. The repo rate now stands at 6.50%, the reverse repo rate at 6.25%; and the Marginal Standing Facility (MSF) rate and Bank rate at 6.75%. The MPC reiterated its commitment to keep headline inflation close to 4 per cent on a durable basis.
The central bank has marginally revised its projection for CPI inflation to 4.8% for second half of 2018-19 and headline inflation for Q1 2019-20 is projected at 5%, with risks evenly balanced. In its previous policy meetings, RBI indicated risks pertaining to CPI projection are tilted to the upside. This has changed with onset of normal monsoon and clarity on impact of increase in MSPs for kharif crops. Factors that make the inflation outlook uncertain on the upside include elevated and volatile crude oil prices, and incremental increase in MSPs over the average increase in the past which was not factored in the June projection. Besides, any further fiscal slippage (both at central and state levels) from the budgeted estimates for 2018-19 may have a significant bearing on inflation outlook. Couple of factors that are expected to have favorable impact on inflation includes, normal monsoon which would help to keep food inflation under check and reduction of GST rates on several goods and services which will have direct moderating impact on headline inflation provided there is a pass-through to retail consumers.
The central bank has retained its GDP growth outlook at 7.4% for 2018-19 within a range of 7.5-7.6% in H1 and 7.3-7.4% H2, with risks evenly balanced and GDP growth for Q1:2019-20 is projected at 7.5%. Signs of improvement in credit off-take are signifying revival in manufacturing sector and new investment activity. Capacity utilization in the manufacturing sector continues to witness improvement with new orders received by companies last quarter saw a substantial growth over a year ago period, reflecting pick up in domestic demand. Recent pick up in domestic air passenger traffic, services PMI, auto sales is expected to boost consumption expenditure. However, major risk to growth outlook is rising global trade tensions which is gradually turning to currency war.
Impact on Economy
Over the last 6 to 12 months, borrowing costs for corporates, banks and other institutional borrowers have been rising with yields across the curve on instruments ranging from CPs, CDs, corporate bonds, T-bills and government bonds rising by 125 to 150bps probably on account of reduced appetite for corporate lending by banks. RBI’s action to hike the repo rate by another 25 bps today might result in a marginal increase in lending rates for corporate and retail borrowers with a lag. CPI based headline inflation has been above 4% over the last few months and given RBI’s primary objective of maintaining an inflation rate of close to 4%, this rate hike is targeted to bring inflation to targeted levels. Based on the pace of transmission of higher rates to borrowing costs, the growth recovery could be negatively impacted. Over the longer term, a fine balance between inflation & growth is desirable and would benefit the economy.
Impact on Morningstar Model Portfolios
They 10-year benchmark G-sec was trading at around 7.76% before the policy announcement, post which in a knee-jerk response yield rose by 9 bps to 7.85%, eventually closing at 7.70%. Yields have remained in a tight range since June MPC meeting as spread between 10-year benchmark G-sec yield and repo rate vis-à-vis historical average indicated that market participants had already factored in a second-rate hike of 25 bps.
In our view, RBI has not made a decisive shift towards a tightening cycle by retaining its neutral monetary policy stance. RBI has indicated that future policy action will be data dependent, based on growth inflation dynamics. The focus being more to keep headline inflation number close to its medium-term target of 4%. The two rate hikes (June and August) were more pre-emptive in nature and RBI might now, probably adopt a wait and watch period indicating a near term pause depending on any change in factors mentioned above having a material impact on RBI’s medium-term inflation expectations. At this juncture, we continue to believe that the short to medium term segment of the yield curve is relatively more attractive vis-a-vis longer end. Over the last few quarters, we have completely exited our positions in long term gilt funds in the model portfolios in favor of short term funds, which in the wake of rising long term Gsec yields, has positively contributed to the performance of the portfolios. Further rise in long term bond yields could make this segment attractive for long term investors.
