A summary of our current macro-framework is as follows:
- Despite sound macros, net capital flow into India has weakened significantly. This predates the West Asia war.
- This seems largely owing to 2 factors: 1> Higher global rates 2> Other competing narratives for global capital flows like the AI theme.
- The West Asia war has further accentuated the balance of payment (BoP) stress, and hence, the funding stress in the system. This to us is the predominant lens from which to view the war, rather than from a traditional growth-inflation trade-off. This is because market rates are reflecting the funding strain more than ‘fears’ of rate hikes. In fact, most market rates are quite attractive priced even assuming a 75 – 100 bps repo rate hike.
- With inflation pressures rising, it is prudent to expect 75 bps or so of repo rate hike over a period of time, as a base case. However, so long as RBI doesn’t lose control of the narrative on how many hikes ahead, this should not worry most of the market rate curve (barring the very front-end points of the government bond curve, which is still relatively steep).
- The cessation of war can provide the first meaningful trigger for alleviating some of the recent funding strain. Given that average levels of commodity prices are still likely to be higher than pre-war levels, and also given that a significant part of the supply shock is already working through product value chains, we would still expect RBI to eventually hike rates. However, as discussed above, this is not a reason to avoid bonds at current valuations.
- Temporary measures to improve capital flows also seem in the offing, given that policy focus currently seems squarely on balance of payments. These can also temporary help alleviate the funding strain.
- A more permanent resolution of the BoP pressure will need one or both two factors discussed above to turn: global rates and / or fatiguing of the AI and allied themes (in terms of incremental capital absorption).
This can turn attention back to other narratives, especially as rupee has cheapened substantially. It is to be noted that the fatiguing of AI theme itself can take rates lower. Alternatively, any weakness in the US labor market may lead to rekindling of Fed rate cut expectations. It is to be noted, however, that for the time being both these (AI and US labor market) seem to be incrementally strengthening.
The Binary
The combination of accentuated BoP stress from duration of the war as well as continued momentum in global rates and capital absorption themes, had led us to go underweight duration again (refer “Turning Defensive: A Macro and Bond Update”). However, since late last week there seems to be more optimism with respect to some resolution to the war. From strictly a markets standpoint, a key variable to track here is the number of ships passing through the Strait of Hormuz. This also seems to have picked up. Should progress continue towards resolution, some of the recent funding stress can very well start to get alleviated domestically. This can happen both via some relief on commodity prices as well as on the rupee. The latter effect can get more pronounced should some credible steps on dollar raising be announced as well.
It is well understood that a lot of the above is binary in nature. Nevertheless, and with as much (or as little) information as is available with us, it seemed to make sense to add back duration risk. We have done so over the latter part of last week, largely via 14- and 40-year government bonds as before. It is to be noted that this is entirely positioning for the binary outcome (with all its attendant risks), and the underlying BoP stress points remain for now. However, the underlying picture has been around for a long time and argues for higher rates overtime than before. This theme may still allow for downward adjustments of yields from current levels, should the binary risk resolve for the better, even as yields remain higher than they were before.
From a valuation standpoint, we continue to prefer the back end of the government bond curve (14 years’ onwards) and up to 3 – 4 years’ corporate bonds. The front end of the non-SLR curve (including money market instruments) is exhibiting very large levels of stress from the funding issue emanating from the BoP pressure. For appropriate investment horizons, and with requisite appetite for intermittent volatility, these now seem quite attractively priced, especially if one level of stress alleviation is around the corner.
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