The Indian economy has been going through a bad phase for some time now. Some of the high frequency data points coming out every month have made it clear that the economy is on a downward trajectory. The Gross Domestic Product (GDP) numbers released every quarter since June 2011 has been on an average 6%. On the other hand, Index of Industrial Production (IIP) has been very volatile. Inflation, which has shown a stubborn tendency to remain more than 9% since February 2010, mellowed to 7%-7.5% if we look at the data points from December 2011. The twin deficits (fiscal and current account) have remained a headache for policy makers.
In the first week of July 2012, we advised investors to take an exposure to short-term funds with a time horizon of around 1 year. The reason behind our recommendation was our belief that along with monetary actions, the government also had to take appropriate steps to bring inflation under control. However, the lack of initiatives from the government meant that the Reserve Bank of India (RBI) will wait till there is some action on the fiscal front before going into a softening monetary policy stance.
There was shift from the gloom when the government did a cabinet reshuffle end-July wherein the pro-reform Chidambaram replacing the conservative Mukherjee as Finance Minister. Two months later, North block started announcing reform measures like hiking of diesel prices, Foreign Direct Investment (FDI) in retail, airlines and media, setting up of National Investment Board (NIB), now known as Cabinet Committee on Investment (CCI) to monitor projects more than INR 1,000 crore in sectors like roads, power and ports. Although these reforms seemed to be a big relief to the Indian naysayers, the major question being asked by both domestic and global investors was the ability of Chidambaram to implement the same in a short period of time. The resolve of the government in implementing reforms can be seen in the fact that the government hiked diesel prices, allowed FDI in Aviation and passed the bill promoting FDI in the retail sector which will in turn promote foreign capital inflows into the country.
As far as the disinvestment targets are concerned, the government had kept a budgeted disinvestment target of INR 30,000 crore for FY13. In the last one month alone, the government went ahead and did a stake sale in Hindustan Copper and NMDC. The stake sale in these two companies gives us the confidence that the government will be able to push for more disinvestments in companies like SAIL, NTPC and BHEL. In addition to this, the 5-year fiscal consolidation map that the government has laid down also means that it is serious this time about containing inflation and bringing the economy back into the 9% growth track.
Although the economy has slowed down for a while now, the central bank has been very clear that it wants inflation to come within its comfort zone. In the mid-Quarter Monetary Policy Review announced yesterday, the central bank indicated that with headline inflation below the RBI’s projected levels over the past two months and the decline in core inflation, there is very likelihood that inflation will moderate in 2013-2014. We are of the view that if the government is able to fill the gaps on the fiscal front and if the currency (INR) shows a tendency to appreciate, then this will have a positive impact on inflation.
Demand and Supply of Government Bonds
We are of the view that in the next few months there might be a bond rally due to demand outstripping supply of government bonds. In the current scenario, the RBI is actively managing the liquidity in the banking system. Banks have been borrowing heavily (in the range of INR 80,000 crore to INR 100,000 crore) through the Liquidity Adjustment Facility (LAF) window, which is above the RBIs comfort limit of INR 60,000 crore or 1% of Net Demand and Time Liabilities (NDTL) over the past few weeks. The central bank has time and again infused liquidity through measures like reduction in Cash Reserve Ratio (CRR) and conducting Open Market Operations (OMOs) which involves buyback of government securities from banks to infuse liquidity. Another important aspect worth mentioning here is the demand for government securities from banks which is set to rise on account of banks adopting to play safe due to their rising Non Performing Assets (NPAs). Banks currently have more exposure to Statutory Liquidity Ratio (SLR) over and above the stipulated ratio of 23%. All these factors could lead to a rally in bonds in the coming months.
Where you should invest now
In the backdrop of the above points raised, we have decided to shift our stance and suggest that investors start taking an exposure into long-term debt funds. The inverse relationship between interest rates and bond prices is something that is known to all who are well versed with fixed income markets. Hence, whenever there is an expectation that interest rates will be on a downward path, then yields on debt instruments tend to fall and consequently the price on the same rises. In such a scenario, we believe that investors with a time horizon of around 1 year should consider investing into income funds. Our recommended funds in this category are Templeton India Income Builder Account, DWS Premier Bond Fund and Canara Robeco Income Fund.