RBI springs a surprise

Oct 05, 2018

RBI surprised markets by keeping the repo rate unchanged with five members voting in favor of the decision and Dr. Chetan Ghate voting for an increase of 25bps. Analysts were expecting a hike in interest rates (by 25 to 50bps) to protect the rupee from further depreciation. Importantly, it changed its stance from neutral to calibrated tightening. Again, five members voted in favor of a change in stance and Dr. Ravindra Dholakia voted for maintaining a neutral stance. Consequently, the reverse repo rate under LAF remains at 6.25% and the Marginal Standing Facility (MSF) rate and the Bank rate at 6.75%.

The RBI sighted lower than expected inflation prints in recent months, particularly in August, due to softness in food inflation despite a rise in fuel prices. It also noted that global commodity prices, other than crude, have been trending lower on expectations of slower growth in the global economy on the back of trade war related concerns. Accordingly, it reduced its inflation forecasts over FY 19 and Q1FY19-20. Inflation is now projected at 4% in Q2 2018-19 (4.4% in the August policy), 3.9% to 4.5% in H2 (4.7% to 4.8% in August) and 4.8% in Q1 2019-20 (5% in August). Although the monsoon season ended with a 9% deficit, advance estimates of kharif production are higher than previous year. Further, reservoir levels are above long-term averages which bodes well for the rabi sowing season. Finally, the HRA effect has receded from June on expected lines. Increase in MSPs in July have been factored in the inflation projections. Key risks to the inflation outlook emanate from rising crude prices, further depreciation in the rupee along with other EM currencies, rising input costs reported by corporates and fiscal slippage at central or state levels.

In its assessment of economic growth, RBI notes that GDP growth was higher than expected in Q1 2018-19, on account of robust private consumption which may sustain despite rising fuel prices impacting disposable income. Going ahead, increased capacity utilization, strong FDI flows and increased financial resources for the corporate sector augur well for investment activity. Although, rising interest rates both global and domestic and rising crude & input prices may negatively impact investment activity for corporates. Rupee depreciation may not benefit exports due to escalating global trade tensions. RBI retained its GDP growth projections for FY 2018-19 at 7.4% as in the August policy and marginally reduced its projection for Q1 2019-20 to 7.4% against 7.5% in the August policy, mainly due to the strong base effect. 

Our view

Softer inflation prints in recent times on account on lower food inflation has contributed to RBI reducing its inflation forecasts. The government’s decision to reduce fuel prices yesterday would have also played a role in RBI holding rates today. But RBI’s shift in stance indicates that they are prepared to act to support the rupee in case recent measures don’t stem further currency depreciation. The RBI and government seem to be walking a tight rope and if market sentiment worsens further and FPI outflows from the equity and fixed income markets continue, RBI may be forced to act by raising rates quickly. 

Impact on Model Portfolios

Equity markets were due for a correction on the back of a strong run-up over the last couple of years resulting in a sharp increase in valuations, as highlighted in our previous commentary. Recent developments on the macro-economic front coupled with issues in the NBFC & HFC sector have triggered a sell-off, particularly in the small and mid-cap space. We had reduced allocation to small & mid-cap funds more than a year ago in favor of large caps. Allocation to international equities in our portfolios has benefited from the sharp depreciation in the rupee coupled with a stronger relative performance in certain global markets, particularly the US. The portfolios have seen drawdowns due to increased market volatility in recent times, although these are lower than market benchmarks. On the fixed income side, we had moved away from long term debt over the last 6 to 12 months and reallocated to short and medium term debt. Further rise in long term yields might make them attractive, although uncertainties are at a high point due to the macro environment. We are closely watching these developments and would apprise in case any changes are warranted in the portfolios.

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