In its second bi-monthly meeting for FY 2019-20, RBI’s Monetary Policy Committee (MPC) decided to cut the policy repo rate by 25 bps from 6.0 per cent to 5.75 per cent. Consequently, the reverse repo rate stands adjusted to 5.50 per cent, and the marginal standing facility (MSF) rate and the Bank Rate to 6.0 per cent. All members of the MPC unanimously decided to reduce the policy rate and change the stance of monetary policy from neutral to accommodative. With CPI inflation well within the targeted range, the focus of the MPC has clearly shifted its focus to support growth as the change in stance to accommodative from neutral suggests that any policy rate increase is off the table as of now.
RBI has marginally revised its inflation and growth forecasts. Headline inflation for H1 and H2 2019-20 in April policy was projected in the range of 2.9-3.0 per cent and 3.5-3.8 per cent, which is now changed to 3.0-3.1 per cent for H1 and 3.4-3.7 per cent for H2, with risks broadly balanced. GDP growth for H1 and H2 2019-20 was earlier projected in the range 6.8-7.1 per cent and 7.3-7.4 per cent, which is now changed to 6.4-6.7 per cent for H1 and 7.2-7.5 per cent for H2.
Several factors provided MPC room to go ahead with another rate cut of 25 bps and change stance from neutral to accommodative – including consistent fall in food prices, benign food inflation outlook, expectation of normal monsoon, slowdown in investment activity, widening of output gap with increased headwinds from a slowdown in the global economy.
Our View
High frequency lead indicators such as weak auto sales, air passenger traffic, muted growth in personal and consumer loans and sluggish rural demand suggest a moderate pace of growth in private consumption expenditure. Latest PMI data also suggest a slower pace of expansion in the manufacturing and service sectors. Although, private consumption is expected to get a fillip from the PM Kisan Samman Nidhi scheme for farmers and expected increase in disposable income of households due to income tax benefits (proposed in the Interim Budget).
Q4 GDP number shows a slower pace of growth in the investment activity. However, resolution of stressed assets is expected to improve credit flow along with a pickup in fixed investment supported by higher construction activity is expected to drive investment activity. Further acceleration in capacity utilization and credit to the industry sector could improve the growth prospects. On the other hand, government expenditure is expected to pick up with a focus on agriculture and rural economy. This is expected to counter the imminent risk of any impact from slowing global economy. Government spending could be supported by increased GST revenue, which is expected to rise by 18.2% (BE FY20). However, much of it is dependent on improvement in economic growth, better tax compliance & reduction in disputes.
To an extent, this rate cut along with change in stance was already factored in by market participants as the yield on the 10-year benchmark G-sec is down by more than 50 bps in the last one month. Nonetheless, a change in stance is coming after two rate cuts, window is open for another rate cut. Although, rate cuts would benefit the economy and support the government’s growth agenda if there is efficient transmission of rate cuts leading to reduction in the lending rates. On the positive side, transmission of previous two rate cuts happened much faster than before as the transmission of the cumulative reduction of 50 bps in the policy repo rate was 21 bps to the weighted average lending rate on fresh rupee loans.
However, few risk factors are still pertinent such as, volatile crude oil prices, uncertainty related to monsoon and concerns over fiscal slippage. Although, government was able to contain fiscal deficit at 3.4% of the GDP in FY19 by deferring expenditure on subsidies. Adherence to the fiscal consolidation roadmap will be a critical task of the government. This may result in increased reliance on disinvestment, small savings and market borrowings to finance fiscal deficit.
On the liquidity front, with increased government spending post-election, regular OMO purchase auctions and dollar swaps – liquidity is expected to be in a comfortable zone. Review of the existing liquidity management framework by internal working group is expected to improve the transparency by RBI clearly communicating the objectives, quantitative measures and toolkit of liquidity management. Surprisingly, the Governor didn’t provide detailed views on the ongoing NBFC crisis and potential impact on the financial sector.
What do our Valuation Implied Return (VIRs) forecasts for fixed income indicate?
On the fixed income side, 10-year return forecasts look fairly stable across the short, medium and long term, and are in the range of 7.2% - 7.9% with medium- and long-term debt offering a tad higher return relative to short term debt. Although, any additional market borrowing via central/state government securities for FY20 along with reduced OMO purchases in coming months (potentially due to the success of dollar swaps being conducted by RBI), rising crude oil prices and concerns over fiscal slippage may put some pressure on the long-term G-sec yields.
How have we positioned our Managed Portfolios?
On the debt side, we’re overweight short, medium and long-term debt, amid attractive real rates. Given that equity valuations are looking stretched, we are holding more cash than what neutral allocations suggest. This should provide ammunition when attractive investment opportunities arise and offer downside protection in case the current optimism unwinds.
