Apr 6, 2023
• Stress in the US and European banks is unlikely to lead to contagion, amid swift central bank actions.
• Central banks continue to hike rates, even as the market expects them to pivot.
• We suggest investors exercise caution but not miss out on opportunities that may arise.
• Change in taxation of non-equity mutual funds to structurally impact fixed income investing in India.
• We remain neutral on equities and positive on gold.
An event-filled first quarter of 2023 felt more like a year, and the coming quarters might be just as eventful. The positive global market momentum seen in the last quarter of 2022 continued into January as the market kept believing a narrative very divergent from what the Fed was saying, only realising in February that it can’t fight the Fed. Last month we saw the first signs of real vulnerability with stress in the US and European banking sectors. However, the market, again, appears to be following a narrative different from that of the Fed.
Back in India, we saw some major tax policy changes which have profound implications for the structure of the financial markets and investor behaviour.
In our January 2023 investment commentary, we wrote that while the Fed remains committed to bringing inflation back to 2%, something in the market could break before that, causing the Fed to reconsider its hawkish stance. The first sign of market disruption was visible in the Silicon Valley Bank’s failure. The fear of a bank run spread to a few more regional banks in the US before hitting the already very weak Credit Suisse in Europe. Reminiscence of the 2008 financial crisis led regulators, in the US and Europe to act swiftly to avoid contagion. The crack in global markets seems to have been sealed for now, until the next one appears.
To understand the US banking trouble, let’s start from the beginning. After the 2008 financial crisis, larger “Too Big to Fail” US banks cleaned up and were forced to cut down on risk significantly, under the watchful eye of the Fed. On the other hand, smaller banks in the US took on the baton of taking risks, away from Fed scrutiny. Those chickens have now come home to roost. The Fed’s Bank Term Funding Program has allowed banks to avoid bank runs. However, the stress in US small banks will lead to tighter lending conditions and thus squeeze liquidity further.
In this context, the market expected the Fed to sound dovish in its monetary policy meeting in March. However, the Fed didn’t blink and raised rates by 25bps to 5%, reiterating its commitment to fighting inflation. While the market is pricing in a 75bps rate cut by end of 2023, the Fed’s dot plot indicates that rates may stay at 5% through the year. A still-tight labour market and resilient economic data suggest a big dilemma for the Fed as there is no evidence of a meaningful decline in inflation. The delicate balancing act of achieving a soft landing has become even more difficult, and we think the Fed is likely to remain focused on containing inflation before turning to growth. Consequently, it may hold off from cutting rates as quickly as the market is expecting.
Market Expectations vs Fed’s Projection
In Europe, the decision by the Swiss National Bank (SNB) to write off AT-1 bonds even as equity holders salvaged some value from Credit Suisse sent shock waves through the system. To calm market fears, the ECB and Bank of England had to make it clear that they would respect the hierarchy of capital structure and will impose losses on equity holders before asking bondholders to take losses. On the inflation front, just like the Fed, the ECB stuck to its rate hike trajectory by raising rates by 50bps. Given an unusually mild winter, the Euro area avoided an energy crisis. However, inflation is likely to persist amid structurally higher energy costs. Strong service activity and a robust job market, like the US, suggest that the ECB may also not ease monetary policy in a hurry.
The Chinese economy, in contrast to the US and Europe, is improving as economic activity normalises. The first two months of 2023 saw some recovery in industrial output, service output, retail sales of consumer goods and PMIs. While these numbers are still well below pre-pandemic growth levels, there are initial signs of an economic recovery. Most importantly the PBoC (China’s central bank) has the elbow room to support the economy unlike most of the rest of the world.
US vs China CPI Inflation
Source: Bloomberg, Sanctum Wealth
Global Markets Outlook
With the anticipation of rate cuts in the second half of 2023 increasing, US bond yields have corrected sharply. The US 10-year bond yield has dropped below 3.5% from more than 4% in early March. The shorter end of the US yield curve has fallen more; however, the yield curve remains inverted. As we have been highlighting, bond market volatility could continue given the uncertain direction of Fed actions.
The equity markets haven’t reacted much to recent developments. Smaller banks in the US have corrected significantly and larger banks to a lesser extent. However, given swift actions by the regulators a larger correction in equities overall was avoided. Earnings downgrade concerns led by slowing growth and weakening consumption patterns have been exacerbated by possible tighter lending standards going forward. We believe downside risks to US equities have only increased.
Source: Bloomberg, Sanctum Wealth
All data are in local currency and are price returns.
Indian Macro Update
High-frequency indicators over the last month have been mixed. While PMIs, IIP and credit grew sequentially, auto sales, air freight and GST collections declined. Overall, data continues to suggest that India is relatively better placed than the rest of the world. However, as highlighted in our previous notes, India is unlikely to be immune to a global growth slowdown.
PMI and IIP data suggest resilience of Indian economy
Source: Bloomberg, Sanctum Wealth
Moving to inflation, India’s CPI inflation in February eased marginally in February to 6.44% while WPI inflation remained on a downward trajectory. Although CPI inflation continues to be outside RBI’s 6% band, it is not as big a concern in India as in the rest of the world. Having said that, the market is expecting the RBI to raise rates by another 25bps in the upcoming monetary policy and then remain on hold for a while.
Indian Market Outlook
While global sentiment impacted India too, its banking sector is relatively immune to the financial sector troubles of the US and Europe as Indian banks are well placed both in terms of quality of deposits and lower impact of mark-to-market losses on the held-to-maturity book. The bulk of bank deposits in India is held by households which tend to be stickier. These investors also have limited exposure to G-secs and debt mutual funds and thus are unlikely to shift to them despite higher bond yields. Additionally, a recent policy change has taken away the taxation advantage of debt mutual funds (more on this later). Further still, mark-to-market losses in India are manageable as the rate hike cycle wasn’t as steep as the rest of the world and Indian banks have sufficient capital to absorb the losses.
Share of retail deposits, as per liquidity coverage ratio (%) Q3 FY23
Source: Jefferies, BloombergQuint
Our neutral view on equities remains unchanged. With concerns about global equities increasing, we suggest investors should stagger their equity investments over the next few months. Our view on fixed income and gold also remains unchanged, however, the route-to-market may change slightly given a recent taxation change. We cover this in the next section.
Impact of Taxation Change on Non-equity MFs
Last month Indian government introduced amendments to the finance bill abolishing long-term capital gains tax (LTCG) benefits on non-equity mutual funds (MFs investing less than 35% in Indian equities) effective 1st April 2023. Now, all gains from these funds will be taxed at the applicable tax rate of the investor. We believe this change will have a structural impact on these instruments and the asset classes they invest in. We try to assess the impact of this change on various investment options that are affected directly or indirectly by this.
Debt Mutual Funds-
Close to half (~INR 8 lakh crores) of debt MF AUM is invested in liquid, money market and similar categories with an investment horizon of fewer than 3 years and hence would not be materially impacted. The balance of ~INR 6.7 lakh crores of non-liquid debt MF AUM will be negatively impacted. Almost all of this is held by either corporates or HNI investors. Given a much higher marginal tax rate for most HNIs, they will be impacted more than corporates. Part of the money could now flow into alternatives like bank and corporate deposits, direct bonds, structured credit AIFs, REITs and INVITs, and hybrid funds.
Debt mutual funds still offer many advantages over the alternatives available like liquidity, the possibility to make higher returns from either credit or duration risk, mark-to-market gains when interest rate falls and diversification. Nevertheless, investors will have to live with lower post-tax returns on their debt portfolio going forward.
Break up of Liquid MF AUM
Break-up of non-liquid MF AUM
Source: AMFI, Sanctum Wealth
Bank and Corporate Deposits-
Bank deposits are likely to be a beneficiary of this tax change. However, debt MF AUM is minuscule compared to ~INR 180 lakh crores of bank deposits. Corporate FDs provide the scope of slightly higher returns than bank deposits, but both bank and corporate FDs suffer from illiquidity and inability to capture capital gains due to a fall in interest rates. As visible in US and Europe, bank FDs are also not fully secured while corporate FDs anyway have credit risk.
A major advantage of investing in debt mutual funds over holding direct bonds was the favourable tax. With the recent change, HNI investors may look to increase direct bond holdings. However, unlike equity markets, the corporate and government bond market in India is largely over the counter. Hence, while there is enough liquidity to do large-size trades, for investors looking to buy bonds in smaller lot sizes liquidity isn’t enough. The government has been trying to increase retail participation in the bond market via platforms like RBI Retail Direct, NSE goBID, etc. However, the response so far has been tepid. With more investors looking to buy direct bonds, liquidity for smaller lot sizes may improve over the next few years. Until then, liquidity will remain a major issue. Also, investors will need to diversify credit risk when investing in corporate bonds. If following the direct investment path, we suggest investors be selective, diversify, and calibrate their overall direct bond exposure depending on liquidity, risk profile, and cash flow requirements.
REITs and INVITs-
The union budget also changed taxation for REITs and INVITs and made distribution in the form of “other income” taxable at the applicable tax rate. With attractive bond yields money has moved into debt mutual funds and from REITs and INVITs, leading to price correction in them. An amendment to the finance bill has provided some relief to REITs and INVITs. With a post-tax yield of 5-6%, REITs and INVITs have again become attractive investment options as the tax arbitrage of debt MFs is no longer available. We suggest investors add REITs and INVITs back to their portfolios.
Source: Bloomberg, Sanctum Wealth
Expected FY23 distribution basis management guidance of respective REIT /INVIT Tax rate assumed at 39% Capital gain tax on “other income” assumed at 15% including surcharges (As other income will be reduced from cost of acquisition as per finance bill amendment)
Structured Credit AIFs
Ever since the IL&FS crisis, credit risk mutual funds have lost a significant amount of AUM to structured credit AIFs which tend to be locked in and hence better equipped to manage the illiquidity of the underlying investments. We have been highlighting how the credit environment in India is more favourable now amid low corporate leverage and still resilient macro indicators. However, we reiterate the need to be selective and understand the risks before adding this to portfolios.
Hybrid Mutual Funds
Most of the hybrid MFs are currently taxed favourably as equity. Investors could use this opportunity to take exposure to fixed income via these hybrid funds by keeping in mind the overall asset allocation. However, it is important to note these are not a replacement for pure fixed-income exposure as the equity component of these funds can add significant volatility and could lead to much higher drawdowns as highlighted below. Also, as we have observed, tax arbitrages can go away quite swiftly.
Source: Morningstar, Sanctum Wealth
Gold and Silver ETFs/Funds
The taxation change also applies to gold and silver ETFs/funds. Physically holding gold and silver is an option but that has issues like liquidity, cost of storage, etc. Sovereign gold bonds are also an option, but secondary market liquidity for the same is limited. Also, investors may have to wait for issuances to take exposure and may have to hold till the maturity of the bond.
Mutual Funds Investing Overseas
India-domiciled mutual funds that invest in securities outside India are also impacted. The SEBI limit on these funds had already reduced options available to investors, and now tax adds another burden. Various platforms allow investors to invest globally via the LRS (liberalized remittance scheme) which could be an alternative now. The budget introduced a tax collected at source (TCS) of 20% on all LRS investments as well. But the actual tax on capital gains is still favourable and the TCS may be offset with advance tax payments.
Overall, this is not the first time such significant tax changes have happened. Taxation on equity has changed 10 times in the last 30 years or so. Even in the case of debt mutual funds, the union budget of 2014 raised long-term capital gains tax to 20% from 10% and increased the holding period to 3 years from 1. Investors and asset managers adapted to these changes and will continue to do so. As they say, only two things are inevitable – death and taxes.