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Lame Ducks to White Swans

Oct 30, 2017

“Knowledge of what is possible is the beginning of happiness” – George Santayana

A mosaic is taking shape, and a picture of an economy with structural low inflation, declining cost of capital, credit score based infrastructure, improving productivity, sound fiscal policy, credit multipliers, public investment multipliers, leapfrog technology, and healthy rural and urban consumers is beginning to emerge.

Driver’s #1- 5: Key Drivers for the Next Leg Up

A fortnight ago, before recapitalization, we wrote about the 5 key drivers for the next leg up (“Key Drivers for the Next Leg Up”, Oct 16th, 2017). They were 1) the multiplier benefits of Aadhaar and a rising credit driven economy, 2) benefits from the transmission of rates, 3) structural low inflation, 4) bottom of the pyramid – rural – rising, and 5) a new definition of India as an emerging market.

Thanks to the government’s bank recapitalization and infrastructure stimulus, additional powerful drivers can now be added.

Driver #6: A Healthy Banking System

Yes, there’s moral hazard at play. Yes, further reforms are necessary. Yes, it will take a while for the PSUs to extend credit. However, the banking system is on its way to being largely healed and this forms the basis for a new normal, alongside the other drivers that are coming into place.

Capital adequacy norms for Basel III would have had these banks requiring capital injections in 2019. The government has addressed the largest worry for investors with no meaningful impact to the fiscal deficit. Further, the rise in PSU bank shares has largely offset the cost of the recapitalization. Equally importantly, systemic default risk has been put to rest.

Driver #7: Front Loaded Stimulus

Our only point here is to emphasize the multiplier benefits of building national infrastructure, in terms of job creation, reducing transportation costs, delivery times and improving productivity. We hope some of the money will be allocated to improving infrastructure in urban areas, which remain key regions of GDP contribution.

Lame Ducks to White Swans

The Modi government inherited a number of lame ducks that one can now argue have been converted into white swans:

GDP growth has accelerated, despite handwringing on the current slowdown. Driven by credit multipliers, easier access to credit, likely lower interest rates, GST efficiencies, infrastructure multipliers, government reform and stimulus, the platform for an economic recovery is in place.
Inflation was running in double digits and now stands at less than 4%.
FDI was lackluster and flows into the country under the current regime are amongst the tops in the world.
Fiscal discipline remains on track. Reserves are at record highs. The currency is generally stable.
Borrowing rates have declined and are likely to decline further.
• The rural economy has stabilized and earnings reports suggest the rural consumer is getting healthier.
• Domestic capital markets are deepening.
• A wealth effect in equities appears to be real and sustainable.
Tax rolls and collections are rising.
Government spending on infrastructure is coming through.
Corporate earnings are better than expected and poised to rise.
Jobs, yes, even the jobs situation is not as necessarily as dire as listed companies are hiring works at rates in line with required growth rates based on demographic projections
The NPAs – a sword of Damocles – of the banking system have been addressed

We’re probably skipping a host of other achievements. The Modi regime inherited a number of lame ducks and in three years has transformed many into white swans.

Which brings us to the last two ducks standing. Those are private investment and real estate. On private investment, substantial capital has been raised via IPOs and the capital markets. FDI and private equity flows have been substantial additional sources of private investment. So while the government figures may not reflect robust capital investment, capital is flowing freely in the economy, except for industry.

Addressing of the nation’s debt overhang is a big step forward and moves us into an elite category of growth economies with a strong banking system. Yes, there are challenges ahead and further reforms are necessary. But let’s acknowledge this as a great step forward.

India is clearly deserving of a ratings upgrade, and we hope ratings agencies will take long overdue corrective action in this regard.

Fixed Income
Banking Recapitalization Will Bring Supply, Competition and Exert Downward Pressure on Rates In the Medium Term

Banking recapitalization, better regulatory oversight, as well as incentives for performance and penalties for under, will force the PSU space to be competitive and aggressive. In the medium term, substantial liquidity and credit are about to make their way into the PSU system, ergo the economy. An increasing supply of credit is a long term positive and will contribute towards a declining rate environment.

Food Inflation Is Likely to Undershoot RBI Estimates

CPI inflation, particularly food, has been brought under control with sound supply chain management. GST is providing further efficiency, via faster delivery and reduced wastage. Sensible management of minimum support prices for kharif crops and two decent years of monsoon add further impetus. With CPI Food being a large contributor to CPI, and the government’s willingness to absorb inflation coming via imported crude, inflation is likely to remain near or under the RBI’s targeted 4% inflation. That’s also a positive impetus for lower rates.

Strong FI Flows Will Remain a Medium Term Positive for Declining Interest Rates…

Strong FI Flows Will Remain a Medium Term Positive for Declining Interest Rates…

…Food Inflation Will Likely To Undershoot RBI’s 4% Target, a Positive for Rates Lower…

…Food Inflation Will Likely To Undershoot RBI’s 4% Target, a Positive for Rates Lower…

…The CRB Commodities Index Trends Remain Benign, Also a Positive For Lower Rates

…The CRB Commodities Index Trends Remain Benign, Also a Positive For Lower Rates

The U.S. 10 Year vs G-Sec Spread Remains Attractive & Capital Will Continue to Flow In…

The U.S. 10 Year vs G-Sec Spread Remains Attractive & Capital Will Continue to Flow In…

…The Repo vs 10 Year Spread Suggests Room for Minor Spread Compression…

…The Repo vs 10 Year Spread Suggests Room for Minor Spread Compression…

…Meanwhile G-Sec vs AAA Spreads Remain In Neutral Historical Ranges

…Meanwhile G-Sec vs AAA Spreads Remain In Neutral Historical Ranges

The Arbitrage Between Indian Debt Yields and Global Yields Will Exert Pressure for Lower Rates

FPIs have reached the conclusion that it’s far more advantageous to own the bonds of a country with strong fiscal discipline, low debt / GDP, strong reserves, low inflation, sound governance and a stable currency regime, instead of negative interest rate bonds.

There’s a fairly strong relationship between U.S. yields and the domestic 10 year g-sec (see chart). With stability in the Rupee, and trillions in negative carry bonds, FIs flows are continuing to find their way into the domestic market via AIF structures.

Global Commodity Trends Remain Benign

The CRB Commodity index has also demonstrated a good correlation with the ten year g-sec (see chart), and the commodity index remains in stable within a larger downtrend, again a positive for domestic interest rates.

Spreads – Neutral

Spreads between the 10 Year G-Sec and 10 Year AAA Corporate bond remain at average levels. For that matter, spreads between the long end and short end also remain in average ranges. The spread between the 10 Year G-sec and the repo rate, however, shows a likelihood of additional rate compression on the part of the 10 year. The spread between the 10 year G-Sec and the 10 year U.S. continues to remain attractive suggesting flows will continue coming into domestic debt.

Fiscal Stimulus, Deficit Funding, Infra Stimulus, the Budget Remain Unknowns

It now appears clear that the recapitalization will not be a drag on the fiscal deficit targets. However, a lack of clarity still remains on the additional 75k crore that is to be raised, as well as the announced front loading of the infrastructure stimulus. Prior to the recap being announced, there were already concerns about the government’s plan on meeting the fiscal deficit targets, as well as the government’s budget plans for next fiscal year.

The government’s borrowing plans are essentially unknowns at this point, though we can surmise that the government is unlikely to be fiscally irresponsible. Net net, not a major cause for worry.

Improving Economy, Easy Money Could Prove Inflationary & Hawkish for Rates

However, if the economy is heading into a recovery, then a concurrent rise in interest rates would be a reasonable expectation. The flood of easy money via the recapitalization can also have inflationary impacts that will exert upward pressure on interest rates. With the spotlight on the RBI’s dollar buying, volatility in the Rupee could also lead to unexpected outcomes.


Fixed Income

In light of the factors discussed above, optimal positioning points towards conservative corporate bond funds. These funds will benefit from an improving economy and a ratings upgrade cycle, which is running 3:1 for the industry.

However, our Products team has identified dispersion in the risk exposure amongst funds within the category. Based on an evaluation of the risk relative to reward, the inherent risk in certain funds is not adequately compensated by potential reward. Our strong preference remains skewed towards conservative corporate bond funds with the majority of paper rated higher than AA and limited exposure to A rated paper. Specifically, the downgrade risk for AA and A rated paper has risen quite substantially. Further, the default risk on A rated paper has also risen.

Second, we remain positive on mispriced aggressive credit opportunities with attractive high yields and the opportunity for upgrades.

Upgrades Are Running at 3:1 Relative to Downgrades…

Upgrades Are Running at 3:1 Relative to Downgrades…

…But There Is a Significant Jump in Default Probability As We Move From AA to A Rating

But There Is a Significant Jump in Default Probability As We Move From AA to A Rating

Source: L&T Finance

Update on AT-1 Bonds

Per Trivantage, experts in AT-1 bonds, demand for AT1 (additional tier 1 capital) bonds issued by state-owned banks had waned due to rising concerns of worsening asset quality, depletion of CET1 (Core Equity Tier-1) capital, distributable reserves and increased needs of provisioning due to NCLT (National Company Law Tribunal) led resolutions process getting activated. The banks issuing these bonds had to pay a significant credit spread to the opportunistic investors but even that was not enough. The liquidity of such bonds in the secondary market had dried up considerably.

But, last week, a lot changed. With the capital infusion announcement, the Government has extended a new lease of life to this high-yield market segment comprising bonds rated AA- and below. The credit spreads have fallen by a range of 50-75 basis points depending on the credit profile of the respective banks. This augurs well for the banks since they now have an opportunity to augment the scarce and much-needed tier-1 capital. Andhra Bank was the first to take advantage of this renewed momentum by raising Rs. 500 crores today at 75 bps below the pre-announcement levels.

However, capital infusion does not solve all the problems facing these banks. These bonds are quasi-equity instruments that carry coupon payment risks that emanate from unavailability of distributable surpluses and lack of sufficient operating earnings. It will be quite clear over the next few weeks that many PSU Banks will still declare significant losses.

Investors who entered this category over the past few years can now expect to make significant returns on their investments, thanks to this momentous announcement. As in the case of PSU Bank stocks, it is quite important for investors to differentiate between the credit outlook of each bank and not get carried away.

We remain positive on select AT-1 bonds, on a case by case basis, managed by a competent portfolio manager.


Recent Curve Steepening & Credit Trends Supportive of Economic Recovery

The curve steepening, particularly at the long end, is supportive of our view of an economic recovery. Further, we’ve discussed trends in bank credit at length in recent commentaries. An economy with robust credit growth, which we are witnessing in rural and consumer, is a healthy economy.

Long End Curve Steepening Is Supportive of Our View of Economy Recovering…
…And Credit Growth Remains Healthy for the Economy, the Consumer and Rural

Long End Curve Steepening Is Supportive of Our View of Economy Recovering And Credit Growth Remains Healthy for the Economy, the Consumer and Rural

Earnings Have Been a Pleasant Surprise Quarter To Date, and Earnings Growth in 2018 Looks Set to Recover

While it’s still early days, we’re pleasantly surprised by the earnings reports to date. The rural consumer has contributed to positive surprises for consumer facing companies and earnings are meeting expectations by and large. Whether it be the recovery in PSUs, Metals, consolidation in Telecom, an earnings recovery is ahead, aided by easy compares versus last year, and fiscal stimulus.

We are entering a new normal in terms of India’s macros. We weren’t willing to write off the structural bull market during the angst last quarter. The government has set the platform for a new normal. Multiplier effects of credit, stimulus and strong demographics look set to unfold. Economic growth and earnings look set to recover.

We remain positively disposed to equities despite high valuations. Sentiment appears to have picked up, which ensures that flows are likely to remain robust. Sectoral allocations will be increasingly important determinants of portfolio performance. Each sector today has a story that appears compelling. Shifting through the opportunities and portfolio strategy around high valuations will be key determinants of future performance.

Technical Outlook

The Nifty50 touched new all-time high of 10366 on Friday and closed at 10323 levels. Global equity markets have been positive with major indices either trading at their new highs or 52 week highs. FIIs bought Rs 6694 (provisional) in equity segment last week who were net sellers over last couple of months. For the last three months price action had been range bound between 10170-9685 odd levels as the index was consolidating its prior gains. Now index has given breakout from this sideways range and continues to move up. Now immediate level for Nifty is seen at 10480 and above that 10650 levels on the upside. Nifty future rollovers at last expiry were above three month average with higher cost suggesting long positions being carried forward. Immediate support zone for the market comes at 10100-10000, where 10000 strike price put option has the highest open interest in Nifty options suggesting as the strong base for the market. INDIA VIX has also retreated to 11.48 levels from recent high of 14.16 which has be supportive for the market.

Technical Outlook