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It Was the Best of Times

Nov 28, 2016


This Week:

  • Debt strategy recommendations and interest rate outlook
  • Equity bottom formation process underway, large caps attractive
  • Why the U.S. 1980s scenario is unlikely to play out this time around
  • Global Gold prospects remain bleak
  • Strategy & Technical Outlook
  • Demonetisation impact on GDP analysis


It was the best of times to be a debt investor these past few years. Yields ranged into double digits and the investing public took it for granted that high single and double digit returns in debt funds was the norm. This week we look at the trends and drivers, and ask at what point does debt become clearly unattractive at the margin relative to other asset classes.

RBI raises Incremental Cash Reserve Ratio & Reduces Liquidity in the System

The RBI raised the incremental cash reserve ratio to suck out Rs. 3.50 lakh crores of liquidity from a banking system flush with cash. This move will serve to stem imbalances in the banking system and will be a negative for banks as they’ll be forced to park the money with the RBI. Cash reserve ratio refers to a part of deposits that banks are mandated to park with the RBI which doesn’t fetch the lenders any interest income.

Monetary Policy meets 6-Dec and 7-Dec , expectation of a Rate Cut

The Monetary Policy Committee, which cut its key repo rate by 25 basis points at its maiden policy on 4-Oct, next meets on 6-Dec and 7-Dec. Since Jan-15, the policy rate has come down by 175 basis points to 6.25%. We would look for a minimum 25 basis point cut, with a likelihood it could be as high as 50 bps. The clamour around demonetisation looks to have settled down. One would think the RBI will want to hold its powder in the backdrop of the rise in U.S. interest rates.

The Attractiveness of a 6.2% Nominal Rate of Return on G-Secs

The greater question we are pondering this week is the retail investor, treasury investor, HNI and FII’s demand for a 6.2%~ yield on G-secs. This to us, is the crux of the question on the demand side. We’re of the opinion that this is far less compelling for FIIs, retail and HNIs at the margin, as evidenced in recent debt market flows.

FII Flows and Mutual Fund Flows Are Waning

In an emerging markets basket, India is still one of the more attractive markets; however, the spread versus the U.S. Treasury has narrowed.

It’s clear from the charts that the FII was a big investor in bonds in 2014 and has been locking in profits and departing. The case for investing in a 6.2% bond with a depreciating currency is questionable at best. The Rupee has once again been exposed as a currency that continues to have the inclination to depreciate.

The retail investor looking at 6% long term returns will not be very thrilled either. While debt funds will continue to do alright, the demand for fixed deposits will wane considerably. It wouldn’t be unreasonable to expect retail investors will now consider commercial real estate and dividend yielding equities as alternatives for their investment flows.

Strategy – Add Income Funds, AT-1 and Tactical Exposure to Rate Movements, Reduce G-Sec

In late July 2016, we stated that we saw a directional move lower in interest rates (see “The Gambler’s Fallacy“, 31-July-16). Today, after a 120 bps move lower, we think much of the juice in the interest rate move appears to have already come through. Further, we now see risks to our forecast, namely unanticipated supply disruptions in food production, unanticipated supply destruction in the SME and small producer sector, disruption in the smooth functioning of the economy. Each of these could lead to an uptick in inflation and rates, alongside possibly an overly aggressive RBI.

The base case now for us would be a stabilisation of rates around these levels, with a possible technical corrective decline in bond prices as traders exit positions.

India and emerging markets stood out as a beacon post Brexit. Trump has changed the dynamics, yet again in favour of the U.S. More importantly, the case for India debt at 6.2% for a foreign investor, in the face of 2-3% annual currency depreciation is not as compelling.

While we continue to believe that there’s a possibility of a further decline in yield, we think it’s a prudent time to lock in partial gains and shift positioning for portfolios that have the ability to do so in a tax advantaged basis.

With substantial exposure to accrual bonds in our model portfolios, we believe the soundest strategy in debt markets today is to add exposure to corporate bonds and move away from government bonds. This would provide the benefit of a higher yield as well as minimal exposure to duration.

Secondly, we’d recommend a diversified portfolio of additional Tier-1 bonds. A review of AT-1 bonds shows that spread compression is likely ahead and this would represent a good opportunity.

Finally, an additional means of benefitting from rate movements is to add tactical exposure to duration via dynamic bond funds. Your Sanctum wealth manager will review your portfolio and suggest changes as appropriate.

The Case For India Debt in a Depreciating Currency Environment Has Become Weaker for FIs

Currency Environment

FI Debt Investors & Domestic Debt Funds Have Been Selling Holdings Aggressively Since Demonetisation

Demonetisation Effect

Spread Compression in Corporate Bonds Relative to G-Secs Is Expected

Compression in Corporate Bonds


The Market Demonstrated Stability in the face of Adverse News Last Week

On 16-Nov-16, we mentioned that times such as these have historically been great times to deploy capital (see “Demonetisation Impacts“, 16-Nov-16). The market has been able to hold its own despite negative news flow, suggesting that a base is being formed.

Our view remains unchanged. We’d be particularly focused on concentrated strategies that aren’t indexed to the benchmark. For once, our preference shifts to quality large caps over midcaps, primarily because many large caps have dropped precipitously and are on offer at attractive valuations.

We continue to believe long term investors will see this episode as a blip in their longer term investment roadmap. We continue to maintain Equities as an asset class are now attractive relative to Debt and bottom up stock portfolios can be constructed at reasonable valuations.

Our fundamental view about the business cycle remains unchanged and we would anticipate an acceleration in the recovery sometime in FY18.

The Domestic Investor Will Provide a Floor for Equity Returns Going Forward

Floor for Equity Returns

Large Caps Are More Attractive Relative to MidCaps

Large Caps to Mid Caps Estimation


Why a U.S. Return to the Reagan Era is Highly Unlikely…

Intermarket relationships have broken down

The stock market is making new all-time highs, even as the bond market is getting crushed. 10 yr. treasury yields are up almost 100 bps since their all-time low in early July. Industrial commodity prices are up strongly, Gold is down, while the U.S. dollar is gaining against almost all currencies. The Dollar normally moves inversely to commodities.

These moves aren’t a portend of doom; rather, they’re indicative of an improving global economic outlook, led by the U.S. The institutional herd believes that the U.S. will witness a repeat of the Reagan style 1980s boom and America will be great again. We hate to be party poopers, but we’re not jumping on that bandwagon.

The U.S. Bond Market is a Strong Headwind

President Ronald Reagan first used the slogan “Make America Great Again”. Trump is using a similar slogan. But Reagan’s slogan had a humongous amount of power behind it because the U.S. was coming out of a devastating 16-year Bond bear market. That bear market ended on 26-Oct-81, when long term interest rates peaked at 15.21%. The U.S. was about to enter a 35-year bull market in bonds, with Greenspan, Bernanke and Yellen adding steroids through liquidity, and borrowing from future demand.

Fast forward to today. The 10 year sits at 2.4% and rising. The U.S. is saturated in debt. The Bond market had President Reagan’s back. President Trump will have the exact reverse situation. The Bond market is going to win. President Reagan was able to operate in an era of persistently moderating inflation and gradually declining rates. President Trump will see the opposite.

The U.S. rode a Baby Boomer With a Median Age of 28 and a 35 Year Bull Market in Treasuries…
…The Equity Market Had a Sub-Par Return in the Prior 15 Years from 1966 to 1981…
Turning the TBill Into an Abnormal Comatose Asset

Turning the Tbill

Why This Time is Different from the 1980s

The euphoria about Mr. Trump’s Presidency is overblown. Mr. Trump faces a bond market bubble, a Fed that’s pumped trillions of liquidity into the system to limited avail and now looking to raise rates, rising yields, potential rising inflation, a fractured and ineffective banking system sitting on a derivatives time bomb, deteriorating demographics, declining labour force participation, a rising number of dependents, retiring Baby Boomers, and a struggling middle class, a divided nation. Moreover, S&P 500 profits have been engineered through buybacks and refinancings. A stronger dollar does not help.


Rumors of Limits on Domestic Gold Holdings

A finance ministry official was quoted last week as stating that the government was considering limits on domestic gold holdings. Gold in dollar terms declined sharply, reinforcing the view that the massive rotation is an expectation of an uptick in economic prospects, and not a rise in risk.

Our expectation is Gold is in the final stages of a move lower. Given the yellow metal is in the government’s sights, we think the outlook for the metal remains risky and we remain comfortable in our underweight position.


Debt Markets & Dislocations

The bond market has made a massive 300 bps move lower over the past five years. We think, however, that the appeal of G-Secs has declined considerably relative to other asset classes such as equities, and even commercial real estate. We think significant chunks of the retail investor, the HNI and the FI investor are unlikely to be compelled to invest in debt.

Secondly, we believe it’s a reasonable time for existing debt investors to consider rotating out of lower yielding G-Secs and locking in higher yields available in corporate bonds and AT-1 bonds and participate in the benefits of yield compression as well as higher coupons.

Impact to Corporate Earnings

While we can certainly expect earnings to be impacted in the current quarter, we think a large portion of demand lost in the current quarter will be recovered in future quarters. Further rate cuts by the RBI will start coming through, alongside transmission of rates.

Government coffers are bound to rise and we would hope we’ll finally see visibility on spending in the upcoming budget.

While near term risks remain on the market adjusting to current quarter, we think the more likely course is the market will be looking towards the budget on Feb 1st come 2017. With accommodative policy, government spending, a relatively strong consumer, we continue to believe the right path is to look forward on a longer term perspective.

Technical Outlook

The Nifty 50 index closed at 8114.3 level up by 0.5% for the week. The 50% retracement of the whole rise from Feb-16 low of 6826 to high of 8969 in Sep-16 comes 7898 levels. Index tested this level last week it touched six-month low of 7916 and has seen bounce back from there.

In the weekly chart, the Nifty has formed a dragonfly doji, which is candlestick reversal pattern, and that too at an important level. On the daily chart, momentum indicators are coming up from oversold levels, and on weekly chart finding support above oversold levels.

FIIs have been sellers to the tune of Rs. 15k crores in the equity market since demonetisation. In the derivative segment also they have reduced their positions on the futures side and overall Nifty futures open interest in the market is at a 17-month low indicating uncertainty in the market. Nifty options have highest open interest build up in 8000 strike put suggesting strong base for market now. Also put call ratio of Nifty options moved up from oversold levels neutral.

Thus, the overall suggestion is that the market could see bounce rally in coming weeks. On the upside index has initial resistance zone around 8164-8174 levels, after that next resistance is seen at 8318-8337 levels up to where this pull back may be seen. On the downside 7900 level will be the critical level for the market, breaking below this index is likely to test 7650 odd levels.

Bounce rally status in the market

Demonetisation Update

To quantify impact of demonetisation on GDP, we review the impact on the M1 supply and its related velocity. While declines in M1 have been offset by time deposits in banks (component of M3) as of 11-Nov-16, it remains to be seen how much of this decline can be offset by the M3 components by the end D-date of 30-Dec-16.

As seen in the table below, the Rs. 17 trillion currency with public needs to go down to a particular value (given that Rs. 15 trillion of this is in the form of Rs. 500/1000 notes) by 30-Dec. Already, we are witnessing a 10% decline slightly offset by 1.1% in the much larger time deposits.

Demonetisation Update

Further, noting MV=PY, and analysing only the impact from M1, we see that M1 velocity has seen a minimum of 12.7 during Jun-12. Currently (as of Jun-16), the quarterly M1 velocity is at 13.2. So we can probably see a 3-4% decline in M1 velocity (easily). Also, looking at M1 itself: of the Rs. 17 trillion, Rs. 15 trillion (of old notes) would be rendered demonetised. Assuming a portion of this as black, this portion should not get back into the system. Hence, we could see some loss in M1 as well. Currently (as of 11-Nov), the loss stands at -5%, but as more white money flows into the system, in a best case scenario we could assume this loss narrows down to -3%.

Net-net, the nominal Q3FY17 GDP could face a 6% decline (3% each from M1 velocity and M1 base) considering M1 base alone. It remains to be seen how much of this 6% is offset by Time Deposits (currently showing a spike of 1% as of 11-Nov-16) and P.O. deposits (currently flat).