Jan 21, 2019
The penalty in terms of likely opportunity cost is just too great to justify being out of the markets – Howard Marks, Sep ‘18
Typical of bull market action, the market continues to react positively to good data (lower inflation) and continues to shrug off bad news (low IIP). Earnings are off to a good start, with key majors reporting good top line and bottom lines, despite an extremely challenging environment last quarter. Brent crude prices dropped mid-way through the quarter, preceding a drop-in inflation, and the NBFC credit crisis has subsided in large part. Looking ahead, the macro environment remains favourable for equities.
With limited signs of excessive optimism, moving forward with cautious optimism remains the prudent course of action. The outlook for emerging markets – and India – remains good in comparison to advanced economies, and the opportunity cost longer term of being out of the markets is high.
The credit to deposit ratio has hit new highs, and credit growth remains healthy at 15%. Fiscal stimulus will most likely be a positive for equities, particularly rural consumption plays. A fair amount of progress has been made on non-performing assets and the stage is set for earnings to come through.
Valuation remains a key issue dogging the market and fears of an adverse election outcome persist, rightly so as one shudders at the thought of returning to the days of 9% inflation and spiking onion, pulses, vegetable prices. Cautious optimism remains our preferred path forward, which translates to strategies, managers and portfolios that minimize losses while ensuring participation in gains.
Slowing Automobile Sales, Rising Shale Production, and Slowing Global Growth Pose a Triple Whammy for Oil
A Peak in Internal Combustion Vehicle Sales
The Financial Times recently reported that peak sales for internal consumption engine vehicles may have occurred in 2018. The Financial Times noted that the world’s three largest markets – China, EU and the U.S. – will stall as EVs begin to gain market share. As metropolitan cities like Bangkok, Shanghai, New Delhi experience worsening pollution, electric vehicles are likely to gain an increasing share of new vehicle sales. This will happen slowly at first, which is where we may be, and then rapidly accelerate.
The global decline in auto sales has been perplexing to many observers, but less so when viewed from the lens of structural change. Many millennials in urban areas don’t want to own vehicles, don’t want drivers’ licenses, eschew the high cost of insurance, maintenance, depreciation, and parking hassles, preferring to be driven around in comfort and renting their usage of an automobile.
A third trend is dramatically rising shale oil production in the U.S. In toto, there are meaningful implications for investment strategy.
The Longer-Term Outlook for Crude Oil
There are direct implications for the longer-term outlook on crude oil. The ferocious amount of speculation makes short term forecasts fraught with uncertainty, but the longer-term picture for crude appears to be clearly benign. This has clear implications for fixed income.
We live in a tech driven business world. Our business, and every sector, is being driven forward in a direction determined by technology. Autonomous delivery, automated retail shopping, online content viewership, declining car ownership, online food delivery etc, technology drives business, and the key takeaway is lower inflation. The cost of a taxi ride today is lower, quicker and easier to schedule. The cost of online content is lower. We live in a lower crude, tech driven, low inflation, Schumpetered (creative destruction) world.
The 10 Year G-Sec Leads the Repo Rate Lower, As in 2014, 2011 and 2008…
…While the 10 – 1 Slope and Spread Suggests a Slightly Weaker but Generally Healthy Economy
10 Year G-Sec to AAA Spreads Have Widened Notably to 110 bps…
…Creating an Opportunity for Spread Compression…
… 5 Year G-Sec AAA Spreads are at Multi Year Highs as Well
Spreads and the Yield Curve
The 10 year G-sec accelerated higher during 2017 and early 2018, before a 100 bps drop earlier this year, bottoming out at 7.25 levels. 2017 was one of the first periods this decade with a clearly positive sloping yield curve greater than 100 bps.
The positive sloping 10-1 curve remains indicative of a generally healthy economy. The recent move lower in rates was in anticipation of accommodative monetary policy but some of that enthusiasm has abated on news of a rural relief package. Net net, there’s some weakness evident in the economy, which remains generally healthy, and supported by accommodative policy.
The G-Sec Normally Anticipates Repo Rate Cuts
Today’s setup looks a lot similar to 2013 as the 10 year anticipated the RBI’s aggressive loosening policy in 2014-16. The 10 year G-sec tends to lead the repo rate lower, as it did in 2014, 2011 and 2008. With the RBI moving to neutral and possibly accomodative, and benign data coming through on inflation, that’s a tailwind boost for bonds and equities.
Spreads – the 10 year g-sec AAA spread (127 bps) and the 5 year g-sec AAA spread (110 bps) – spiked higher post the IL&FS default in Oct ’18. Since then, the central bank’s OMO operations, lower crude, and lower inflation have positively impacted g-sec yields. In both the 5 and 10 year, spread compression looks to be a higher than 50-50 probability outcome. Moreover, corporate bonds generally tend to respond to g-sec movements with a lag.
Liquidity Surged Post Demonetisation, Understandably So…
…Liquidity Remains Near System Neutral Today…
…While Net Borrowings Remain Lower Than Prior Fiscal Year
AAA – NBFC 1 Year Spreads Had Blown Out to 40 bps But Contracted to 26 bps this Week…
… 3 Year Spreads (40 bps) Remain Slightly Above Historical Ranges
While AAA to AA Spreads Remain at Slightly Above Average Levels,
AA to A Spreads Remain Elevated…
Systemic Liquidity At Market Neutral and Within Historical Ranges
Both the RBI and the NBFCs appear to be right in their assessment. NBFC spreads have risen and second third tier NBFCs are experiencing difficulty as the CP market has shrunk considerably for NBFCs, and NBFCs are clamouring for additional liquidity measures or a liquidity window to the RBI. The RBI is looking at systemic liquidity that is at close to appropriate for the economy and not witnessing signs of stress at the macro level and rightly unwilling to be lender of last resort to default quality loan portfolios.
Opportunities in AA Bonds
One of the risks with venturing into the A rated paper is that it is a thinly traded market, and mark to market can be a chimera and many securities are not being marked to market. What’s remarkable is the 100-150 bps spread that A paper yields over AA, a range that has persisted for the past 2-3 years. The corresponding yield spread between AA and AAA is at most 50 bps.
One fund manager recently recommended a move away from A paper to AA paper, as their view was that much of the A paper was largely illiquid and had not been marked to market. In general, the fund manager and investors in consensus prefers higher quality credit.
Viewed from a longer term prism, rightly so, as AA paper has delivered returns in line with A paper with much lower risk. There’s clearly opportunity for yield enhancement in AA rated paper for the adept and savvy debt fund manager. Corporate bonds have delivered meaningful incremental returns above long term gilts.
AA and A Paper Has Delivered Strong Returns Over Longer 3 and 5 Year Periods…
U.S. Interest Rates Decline and Fed Policy Shift a Positive for India
The consensus around a slowing U.S. economy is not visible in key data yet. The PMI data remain solid, employment is strong and real consumption spending is healthy. The yield curve remains positively sloping. The Fed is leaning towards neutral and supportive. Markets suffered a swift and painful 20% correction, and froth has come out of the markets. The move lower in the 10 year and the curve in general is in line with expectations that the Fed is likely done with rate hikes and excess froth has exited the system. Lower U.S. rates are a positive for Indian markets.
The U.S. Yield Curve Has Shifted Lower with the 10 Year at 2.71%…
…Remaining Positively Sloped Versus T-Bills, and the 2 Year
There are a couple of strategies that we’d like to highlight:
• Longer term trends bode well for a decline or stability in crude prices and continued lower inflation
• The real interest rate spread remains high, which again argues for a downward drift on rates longer term
• If our call on interest rates heading lower longer term is right, then some exposure to moderate duration for yield seeking investors, tactically added post moves higher in interest rates, is likely to deliver incremental yield
• As discussed earlier, yield seeking investors with a willingness to bear some volatility in debt portfolios are likely to be adequately compensated for the additional risk
• Investors may want to review their exposures to A rated paper and move to higher quality paper
• Rates could head further higher on announcement of rural relief package or the budget. We’d look to use these opportunities to allocate capital into fixed income portfolios.
In constructing portfolios, investors should keep in mind that actual inflation for high net worth investors is likely averaging mid to high single digits. Food and fuel make up a limited part of the monthly spend. A depreciating currency, rapidly higher costs of manpower in urban areas, services, healthcare, overseas education, more expensive travel, and entertainment are all growing at a much faster clip.
If real inflation is in fact in the mid to high single digits, it underscores the necessity of maintaining healthy allocations to yield enhancing products including equities and alternatives, will ensure portfolios preserve and increase purchasing power.
After initial hiccup of the week, Nifty bounced back immediately and then consolidated with flat closings for the remainder of the week. For the week Nifty closed higher by 1% at 10907 levels. Index has been consolidating for the last six weeks and has been witnessing narrowing of the range. Thus, suggesting market is likely to see breakout from the range. Though the upside has been capped at 11000, Nifty has been forming higher lows since its October low indicating buying coming in at higher levels. Thus, las week’s low of 10692 becomes critical level for the market move higher. Holding above 10692 levels, Nifty needs to cross 10985 levels on momentum and sustain above it for breakout to be confirmed. Then index can rally towards 11090 and 11160 levels initially. On the downside declining below 10692 levels, market will can see breakdown towards 10535 and then 10350 levels. In Nifty options, maximum open interest for Puts is seen at strike price 10700 followed by 10500; while for Calls it is seen at strike price 11000 followed by 11200. Open interest in Puts moving higher suggesting supports are shifting higher. India VIX closed at 16.62 levels up by 8.3% for the week. It needs to move below 16 levels for market to breakout on upside and move higher.