Positioning for Disinflation
We are well past the peak inflation of 2022.
Yet, inflation continues to be the focal point of all the policy discussions
and investment thesis in 2023. Central banks, though somewhat less aggressive
than last year, remain in inflation-fighting mode. Markets are divided on whether
to follow central banks in fighting inflation or fight the central bank itself
against raising rates.
Amidst all this, inflation numbers have started
showing some interesting trends. The headline CPI inflation dropped by 169
basis points in the fourth quarter of 2022, from 7.41% YoY in September 2022 to
5.72% YoY in December 2022.
Some softening in inflation numbers was widely expected
due to seasonal drop in vegetable prices with winter crop arrivals and base
effect turning favorable. But, the quantum of disinflation in the last two
months surprised almost everyone on the street.
As per market consensus estimates, CPI
inflation was expected around 6.3% in November 2022 and 5.9% in December 2022.
Actual headline CPI came at 5.88% and 5.72% respectively. The gap was almost
entirely contributed by a larger than expected drop in vegetable prices which
fell by a cumulative 21% in the last two months of 2022.
The CPI inflation ex-vegetables inched up to
7.2% and the Core CPI (CPI excluding food and fuel) remained sticky around 6.1%.
Thus, at a broader level inflation remained elevated when calculated as year-on-year
price changes.
However, on a sequential basis (month-on-month
price changes) inflation has been cooling off across various household goods
and services. Energy prices have also stabilized after a sharp jump in the last
year.
Food inflation ex-vegetables though remain
elevated, should also come down as increased Rabi sowing and colder winter are
expected to boost food output and thus reduce price pressure.
With the current trend, inflation should fall
closer to 5% in FY24.
Chart – I: Incremental inflation has been
moderating across many items
|
|
|
Average
Month-on-Month Change (%) |
||
|
|
Weight (%) |
Apr-Jun 2022 |
Jul-Sep 2022 |
Oct-Dec 2022 |
|
Basic Food |
14.9 |
0.71 |
0.53 |
0.67 |
|
Meat, Fish, Egg & Milk |
10.5 |
0.97 |
-0.21 |
0.57 |
|
Fruits & Vegetables |
8.9 |
2.89 |
0.97 |
-4.51 |
|
Processed Food Items |
11.2 |
1.08 |
0.97 |
0.73 |
|
Household Goods |
14.4 |
0.70 |
0.61 |
0.49 |
|
Services (Ex-Housing) |
13.8 |
0.66 |
0.50 |
0.24 |
|
House rent |
9.5 |
0.26 |
0.56 |
0.26 |
|
Energy |
9.3 |
1.80 |
0.46 |
0.37 |
|
Medicines |
4.0 |
0.47 |
0.46 |
0.72 |
|
Gold |
1.1 |
-0.18 |
-0.58 |
1.86 |
|
CPI Headline |
100.0 |
1.01 |
0.53 |
0.05 |
|
CPI (ex- Fruits & Vegetables and
Gold) |
90.0 |
0.83 |
0.50 |
0.49 |
Source – MOSPI, Quantum Research, Data upto
December 2022
Policy Implication
Though inflation is still above the RBI’s 4%
target, it would take comfort from the declining sequential momentum. The RBI
has covered significant ground in reversing monetary policy from historically
low policy rates and highest ever liquidity buffer to something more consistent
with long-run neutrality in the Indian context.
Chart – II: RBI Frontloaded Monetary Tightening to Tackle Inflation
Source – RBI,
Quantum Research, Data as of December 30, 2022
Past Performance may or may not sustain
Now, the most likely scenario for the monetary
policy seems like a one of a long pause with the repo rate staying at 6.25% for
the entire 2023. This view is based on the following:
a.
Inflation
is moderating on a sequential basis and is likely to remain well within the
RBI’s upper tolerance threshold.
b.
Real
policy rate (Repo Rate minus CPI inflation) are now more than 100 basis points
based on expected average 12 months forward CPI inflation.
c.
Sluggish
recovery in domestic demand keeping GDP growth below the long-run
potential.
d. The external monetary environment is showing some signs of easing amid falling global inflation and slowing pace of rate hikes by the US FED.
Chart – III: Rapid rate hikes took the policy rate above expected inflation
Source- MOSPI,
Bloomberg, Quantum Research; Data upto December 2022
@12 months Forward inflation during 2022 is based on estimates of the Quantum Research team. | Past Performance may or may not sustain
Impact on Market
Pause in monetary policy in itself will be
positive for the fixed-income market. At
current valuations, the bond market has built-in significant uncertainty
premiums for future monetary policy.
The 10-year government bond yield is currently
trading around 7.3% which is over 100 basis points above the Repo rate. Considering
monetary policy is around peak rates, this spread between the 10-year bond and
the repo rate seems too wide. This makes the medium to long-duration bonds
attractive buy at current valuations.
However, there are other factors that will have
a significant impact on the bond market in the months to come. We are
particularly concerned about the following:
1) Fiscal Discipline: The union budget for 2023-24 will be presented against the backdrop of a slowing global economy and sluggish domestic demand. This will also be the last full budget before the general elections in 2024. Thus, there will be aneed and temptation to boost spending. While on the other hand, tax collections will likely moderate in FY24 in line with the decline in nominal GDP growth.
The bond market will be highly sensitive to the government’s fiscal consolidation path. The market is prepared for a fiscal deficit of around 5.8% of GDP and a gross market borrowing of around Rs. 16 trillion. Any meaningful deviation on the upside will be negative for the bond market and will push yields significantly higher.
Chart – IV: Fiscal Consolidation to 5.8% of GDP required to reach the 4.5% medium-term goal
Source- Indiabudget.gov.in, Quantum Research; Actual
Data upto FY23
@Quantum Research estimates for FY24
2) Bank
Credit-Deposit gap – Bank credit growth is currently hovering around 15%-17%
year on year. While deposits growth is around 9%.
In order to fund
the increasing credit demand, banks will have to – (i) increase market
borrowings, (ii) raise wholesale deposits at a higher cost, or (iii) liquidate investments
in bonds.
The pressure on banks’ resource profile will increase as the liquidity condition tightens at the system level. Based on historical trends, we would expect cash withdrawals to pick up during January to May period reducing the core liquidity by around Rs. 2.8 to3.2 trillion by April-May 2023.
In absence of any durable liquidity infusion by the RBI, short-term yields will move significantly higher and credit premiums will widen across the yield curve. This could also reduce the bank's demand for bonds in FY24.
Chart – V: Wide gap between Credit and Deposit Growth Risk for Bond Demand
Source – RBI, Quantum Research; Data upto December 30, 2022
In conclusion, the bond market will face
intense push-pull forces from falling inflation and stabilizing monetary policy
on one side, and deteriorating demand-supply dynamics on the other side.
Although the near-term outlook is clouded by
the uncertainties around the demand-supply balance, we remain positive on the
bond market from a medium-term perspective. We broadly expect the 10-year
government bond yield to trade in the 7.0%-7.5% range.
What should Investors do?
With most of the government bond
yield curve above 7%, the accrual yield has improved significantly in the bond
market. Currently, government bonds across all maturities are trading above the
expected 12-month forward CPI inflation.
Higher starting yields auger well
for fixed-income returns as it increases the interest accrual on fixed-income
instruments. Also, with monetary policy
stabilising, there is room opening up for capital appreciation over a medium-term
horizon.
Chart – VI: The real rate is positive across the yield curve
Source – Refinitiv, Quantum Research, Data as of January 20, 2023
Past Performance may or may not sustain
All in all, the return potential
of fixed-income funds has improved and the next three years are likely to be
more rewarding for fixed-income investors than what we witnessed in the last
three years.
We suggest investors with 2-3
years holding period should consider adding their allocation to dynamic bond
funds.
Dynamic bond funds have the flexibility
to change the portfolio positioning as per the evolving market conditions. This
makes dynamic bond funds better suited for long-term investors in this volatile
macro environment than other long-term bond fund categories.
A Dynamic Bond Fund or any other
debt fund which invests in long-term debt instruments are highly sensitive to
interest rate movements. Thus, in a short period of time, returns could be
highly volatile and can even be negative. However, over a longer time frame of
over 2-3 years period, returns tend to normalize along with the interest rate
cycles.
Chart-VII: Bond Fund Investments require a longer holding period
Source – AMFI Portal, Crisil, Quantum Research; Data as of December
30, 2022
Past Performance may or may not sustain
Investors with shorter investment
horizons and low-risk appetite should stick with liquid funds. With the increase
in short-term interest rates, we should expect further improvement in potential
returns from investments in liquid going forward.
Since the interest rate on bank
saving accounts are not likely to increase quickly while the returns from the liquid
fund are already seeing an increase, investing in liquid funds looks more
attractive for your surplus funds.
Chart – VIII: Liquid Fund Yields Moved up Tracking Treasury Bill Rate
Source
– Refinitiv, Quantum Research; Data as of December 30, 2022
Past Performance may or may not sustain
Investors with a short-term
investment horizon and with little desire to take risks should invest in liquid
funds which own government securities and do not invest in private sector
companies which carry lower liquidity and higher risk of capital loss in case
of default.
Portfolio Positioning
|
Scheme
Name |
Strategy |
|
Quantum
Liquid Fund |
The scheme continues to invest in debt securities of
up to 91 days of maturity issued by the government and selected public sector
companies. |
|
Quantum Dynamic Bond Fund |
The scheme continues to invest in debt securities issued
by the government and selected public sector companies. The
scheme follows an active duration management strategy and increases/decreases
the portfolio’s sensitivity to interest rates in line with Interest Rate
Outlook. The bulk of
the QDBF portfolio is currently into 1-3 years maturity Gsec and PSUs. This
tactical position is consistent with our near-term uncertain outlook. We
remain positive from a medium-term perspective. But will wait for some of the
near-term uncertainties to pass before adding risk to the portfolio. |
Disclaimer, Statutory Details & Risk Factors
The views expressed here in this article / video
are for general information and reading purpose only and do not constitute any
guidelines and recommendations on any course of action to be followed by the
reader. Quantum AMC / Quantum Mutual Fund is not guaranteeing / offering /
communicating any indicative yield on investments made in the scheme(s). The
views are not meant to serve as a professional guide / investment advice /
intended to be an offer or solicitation for the purchase or sale of any financial
product or instrument or mutual fund units for the reader. The article has been
prepared on the basis of publicly available information, internally developed
data and other sources believed to be reliable. Whilst no action has been
solicited based upon the information provided herein, due care has been taken
to ensure that the facts are accurate and views given are fair and reasonable
as on date. Readers of this article should rely on information/data arising out
of their own investigations and advised to seek independent professional advice
and arrive at an informed decision before making any investments.
Risk Factors: Mutual Fund investments are subject to
market risks, read all scheme related documents carefully.
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