These are maxims that are oft repeated in the capital markets. While they make perfect intuitive sense, they require courage and character to implement. How the whole world wanted to buy equities at the beginning of 2008, but at less than half the price, equities had no takers towards the end of the year. Today, we are experiencing a similar situation in the debt markets. With interest rates on the rise, there are no takers for debt instruments. Debt mutual funds have also reduced their residual maturity to abysmal levels. So is the interest rate cycle turning and therefore does there lie an opportunity in the debt markets, especially in the longer dated paper?
The Reserve Bank of India (RBI) has made it amply clear that anchoring inflationary expectations is going to be their main objective in the near future. From an emphasis on ‘managing growth while controlling inflation’, the emphasis has shifted to ‘controlling inflation’. While inflation has come down to single digit territory (9.97% for the month of July), it yet remains far beyond the RBI’s year-end target of 6%. Therefore, it is most likely that there could be one or two more interest rate hikes. However, such increases are expected to be small in size, lest one sees a flood of foreign capital swamping our capital markets, thereby creating inflationary pressures. Further, the hike in interest rates should be steeper on the shorter end of the curve, with the intention of narrowing the LAF corridor. In fact, this is what had happened in the last round of interest rate increase, when the repo was increased by 25 basis points but the reverse repo was increased by 50 basis points.
Besides, the base effect should kick in very soon. Inflation had turned positive in September of last year and there was a steep spike in the Wholesale Price Index in November 2009. Therefore, inflation (in percentage terms) should come down by itself, without any decrease in the price level. With a good monsoon, food prices should also come down. And with the global ‘recovery’ halting, the price of commodities should also remain low. Already oil has receded to about $73 per barrel. We have all along reiterated that this ‘recovery’ has happened only because Governments in the developed world have printed currency and have indulged in all sorts of manipulations. And therefore, we strongly believe that the world, or at least the western world, will once again move into negative growth territory.
Besides, there is great news coming in on the fiscal side. It is quite likely that the fiscal deficit for FY11 will be lower than the 5.5% of GDP, as projected in the Union Budget. This is evident from the figures given below, which have been extracted from the Statement on Quarterly Review of the trends in receipts and expenditure for Q1FY11.
Thanks to the buoyant economy, the tax collections in the first quarter have been excellent. This is especially in the case of indirect taxes. The quarter on quarter increase in excise duty was 52%, customs duty increased by 62.2% and the service tax by a relatively modest 9.1%. The quarter on quarter increase in corporation tax was 23.7% and income tax collections were higher by 13.8%. Besides, the Government just raked in a bounty at the 3G and the BWA auctions. As a result of this, revenue receipts increased by 177.5% as compared to Q1FY10. Further, the Revenue Deficit is just 3.8% of the Budget Estimates (38.1% for Q1FY10) and the Fiscal Deficit is just 10.5% of the Budget Estimates (31% for Q1FY10) for Q1FY11. Therefore, borrowings are down by 67.7% in Q1FY11.
The GDP figures for Q1FY11 were unveiled on August 31, 2010. While the GDP grew an impressive 8.8%, the numbers do suggest some weakness on the demand side. Private final consumption expenditure increased a mere 0.3% in real terms over the corresponding quarter of the previous year. Government consumption spending actually shrank 0.6%. Further, gross fixed capital formation grew by just 3.7%. Exports and imports declined by 4.3% and 1.9% respectively, using constant 2004-05 prices. The RBI Governor will surely have these numbers in mind when he goes in for the review of the Monetary Policy later this month.
Owing to these reasons – that inflation has probably peaked, the fisc is going to hurt less than expected earlier and the weak demand side data, we feel that interest rates have peaked. At most, one could see one more rate hike of 25 basis points.
Therefore, it may just be the time to start investing in debt mutual funds, especially into funds with a longer average maturity. Due to the likelihood of one more rate hike, one could run a Systematic Investment Plan over a 12 month period. Further, with equity markets at a 30 month high, fund managers may just want to start rebalancing portfolios.
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