The unexpected corporate tax cuts alongside previous measures announced over last few days by the government amount to a total fiscal expansion of around 0.8% of GDP at face value. That said, private estimates are between 0.2 – 0.4% shy of the government’s estimate. We discuss below growth, monetary policy, and bond market aspects of the move:
Growth
With this the government has shown a clear commitment to shore up growth even with its back against the wall, fiscally speaking. Further, it has resisted an easy consumption stimulus which may have had very little multiplier effects and possibly may have eventually contributed to some macro- economic imbalances. Rather the tax cuts will help improve corporate profits and hopefully improve our global competitiveness. Further incentives for new units announced may also help with attracting some of the global supply chains reallocations that are underway given escalating trade tensions.
However, this may not necessarily be a substantial shot in the arm for near term growth prospects. The tax cuts may be used in a variety of ways including stepping up investments, reducing debt, cutting product prices, increasing salaries, buyback and dividends etc. All told, the immediate pass through and growth impulse created may be not as strong and thus the tax buoyancy hoped for on the back of stronger growth may have to wait for a while. This is especially true as general competitiveness in an increasingly challenging world requires other aspects of factor input efficiencies to fall in place as well.
Monetary policy
Prima facie if, unlike earlier expectation of limited further space, fiscal policy has indeed chosen to step up to the plate then monetary policy needn’t be as aggressive, all else being equal. That said, the global and local context is weak enough to argue yet for some (though not substantial) incremental role for monetary easing. This is especially true because Governor Das doesn’t appear to be as large a fiscal hawk currently (indeed welcoming the bold step from the government, after observing one day prior that fiscal space seemed limited). We would hence look for monetary “teasing” incrementally, as opposed to “easing “that we were expecting before and would expect the repo rate to bottom out in the 5 to 5.25% area. The one caveat to this view is of further global growth deterioration which would then open up room for further easing. Whereas, liquidity policy is expected to remain of substantial surplus.
Bonds
As noted before term spreads have been quite wide for this part of the cycle, largely reflecting the inadequate availability of risk capital versus the supply of bonds (the same inadequacy is being reflected as higher credit spreads in the loan and credit market). Despite more than adequate liquidity now, risk capital has been cautious possibly due to lack of confidence on market risk given the fiscal and bond supply overhang. Since a large term premium has already existed, we wouldn’t expect a significant further expansion just because the risk has now materialized. Further we don’t expect the entire expansion to manifest in the center’s fiscal deficit. After sharing this with states and accounting for other levers built in (some of which were discussed in a previous note), we are looking for a final fiscal deficit of 3.7% versus the 3.3% budgeted. This will entail some additional bond supply eventually, but with the cushion that the center’s net bond supply was slated to fall substantially in the second half of the year versus the first.
Portfolio Strategy
With the prospects of monetary easing somewhat diminishing in incremental intensity, and accounting for the somewhat higher bond supply, we may expect some amount of curve steepening going forward. This may likely happen as market participants anchor themselves to 3 thoughts: One, liquidity will remain abundantly surplus. Two, repo rate is here or modestly lower. Three, prospects of a very large bond rally are somewhat diminished (although this view will evolve going forward depending also on how much net additional supply actually manifests for local absorption) . This will likely increase appeal for the front end of the curve versus the longer duration, hence creating steepening pressure.
Reflecting the above thought, we have cut our recent duration elongation into the 10 – 14 year segment and are now refocussing on being overweight 5 – 7 year for government bonds in our active duration funds. For AAA corporate bonds, the relative value continues in up to 5 years. These segments could better align to what remains an environment of abundant surplus liquidity, a very attractive term spread, still general lack of credit growth, and continued global monetary easing.
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