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Inflation story: picture abhi baaki hai

Lakshmi Iyer, CIO (Debt) and Head, Products, Kotak MF

In a nutshell

While structurally, the inflation trajectory points downwards, there could be near term pressures stemming from the 7th Pay Commission induced demand fillip, and a wider tax net under the GST regime driving up costs. Lakshmi says in this context that the relatively benign CPI headline of 5.08% could well be a case of "Picture abhi baaki hai", at least from a near to medium term perspective. She is not unduly worried about FCNR redemptions and their impact on the currency, and believes that the currency could remain well supported as FIIs increasingly take to Indian debt, which appears a great asset class for yield seeking FIIs to be in right now. Read on as Lakshmi takes us through where she sees the best opportunities now in the Indian debt market, against this backdrop.

WF: The rupee is now in focus on account of conflicting signals about the need for some depreciation as well as concerns around the impact of FCNR deposits redemption. What is your view on the rupee over the rest of this fiscal and how do you expect currency markets to impact our bond markets?

Lakshmi: The FCNR redemptions of around US$ 20 bn is likely to cast some downward pressure on the Rupee from time to time in the next 1-2 months. However, we believe that RBI is adequately prepared for the task. In fact, RBI may intervene in the market by means of OMO to provide liquidity support from any kind of FCNR redemption pressure. This may actually help pull down the yields.

The recent FOMC decision of status quo also is likely to be supportive of most currencies, including the rupee

Global trade trend is quite subdued. In the first quarter of CY16, the world trade declined by 1.16% over the December 15 quarter. In comparison India has actually done pretty well. Indian exports in August 16 have fallen by 0.3% over Aug-15 while imports by were down by 14% yoy. The overall net trade deficit for Apr-Aug 16 period has contracted by 40%. Thus the macro pressure on the Rupee is relatively low.

Having said that, globally there is a competitive trend to depreciate the currency to boost up the exports and India may feel its heat some point or the other. But for now, we believe that there is stability in the Rupee and it may continue to remain a better performing currency for some more time. Thus from this perspective bond market can take succour. This is also useful for foreign flows into the country.

WF: There is a perception that inflation targeting will continue to be a focus for RBI under the leadership of Mr. Urjit Patel. What is your sense on inflation over the coming 6-12 months and to what extent can this impact the trajectory of interest rates?

Lakshmi: Monsoons have been good, the aggregate supply capacity of the nation is improving, infrastructure bottlenecks are getting resolved, and oil prices continue to remain favourable for importing countries. So as such, the inflation trajectory is on a downward spiral for the next few months. The uncertain variable in this matrix is the demand fillip from the 7th pay commission and the impact on prices by GST.

The recent benign CPI headline (5.08%) that we saw could well be a case of " Yeh tho trailer..Picture abhi baaki hai.." Having said that, we believe that inflation may tend to range in the 4-5% for most of the remaining financial year. Farmers in the movie 'Lagaan' looked upto the skies for rain. Here, the rain gods having smiled already, markets would look upto the RBI for some rate reduction act. We believe there is a case for the RBI to ease rates by 25-50 bps rate cut in coming months.

WF: Some experts believe that irrespective of domestic inflation, it is FII inflows into Indian debt markets, led by an exodus from low yielding markets, which can influence yields in our market and push them down. How do you see this variable playing out and influencing yields in our market?

Lakshmi: Calendar Year to date, FIIs are net sellers in Indian bond markets. Yet bond yields have only headed lower. CY 2015 we received over 50,000 cr FII flows in debt. Yet bond yields moved marginally. Key to realise is that India is perhaps one of the countries that provide such high yields on its sovereign bond. At that India has a stable currency regime; and it has a moderating fiscal deficit projection. This is too good an opportunity to miss; and FIIs should certainly not lose out on that.

Currently, strong Indian fundamentals, aided by low/negative yields in the rest of the world have acted as strong catalyst to southward movement in Indian rates. We expect FIIs to take note of this, and add net positive flows in the months to come

WF: Where do you see the best opportunities today in our fixed income market?

Lakshmi: Often the best opportunity perceived is what is seen at hindsight! In the last 1 year duration funds like gilt and bond have been the best performers in the fixed income space. The portfolio yields have hence reduced to that extent. Despite that, duration funds remain a viable option in the current scenario where interest rates are likely to ease further. Funds in the corporate bond space, which predominantly thrive on coupon accruals, should be an integral part of ones fixed income allocation. This gets even more pronounced as sovereign and AAA segment yields have been receding. Such funds have a relatively higher portfolio yield, coupled low to moderate duration. As banks delay rate transmission, there is high potential to sight investment opportunities in the corporate bond space.

WF: What product strategy makes most sense now in the fixed income market?

Lakshmi: A combination of accrual plus duration strategies is what makes sense at the current juncture in fixed income investing. Being lop sided into either of these would not be a prudent thing to do. Like a balanced diet offers carbohydrates, proteins, fats etc, one should seek a balanced portfolio as well.

Accrual based strategies are more like the actual cake, with icing coming in the form of duration funds. This, in the current interest rate scenario, is likely to offer a stable bias on ones fixed income portfolio.

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