The Union Budget 2018 came in the backdrop of an extremely nervous bond market. The reasons for the massive sell off in bonds over the past 6 months is well documented before. The latest skittishness has been over a sharp rise in oil prices and considerably deliberate (but mysterious) uncertainty being introduced with respect to the current year’s borrowing calendar. On the latter, the government/ RBI have largely wasted the announced INR 30,000 crores reduction in extra borrowing in terms of its effect on bond yields. Thus for some strange reason it was decided to cut the borrowing from the longest 2 securities for the most part (where there was presumably assured demand from insurers) rather than the so-called ‘belly’ of the curve (where the pain was maximum from lack of absorptive power of general market participants).
Given this context, the bond market was hoping to be delighted by the Budget. Had the finance minister chosen to stick to the initial glide path on fiscal deficit and announced 3% deficit target for FY19, that would have constituted such a delight. As it turned out, the minister revised current year’s deficit to 3.5% and announced 3.3% for the year ahead. Having said that, he also adopted recommendations of the new FRBM with a commitment to reach 3% by FY 21.
The table above highlights some key metrics from the budget. As things stand, it is a prudent enough budget. Thus total expenditure grew by 12.3% in FY18 while the nominal GDP grew by 10%. However, in FY19 total expenditure is budgeted to grow by only 10.1% even though nominal GDP growth is higher at 11.5%. Thus there is decided compression in expenditure to GDP despite calls for a ‘stimulatory’ budget. Furthermore, there is more reliance on tax revenues to fund spending with budgeted capital receipts scheduled to rise only modestly. There are some questions pertaining to the aggression assumed particularly related to the GST collections. However, this remains an evolving situation and with compliance stabilizing and a cyclical recovery underway, the government may yet meet the target. From an aggregate receipts standpoint, there is some cushion possibly this time on the disinvestments receipts which can be leaned on more heavily later in the year should tax receipts undershoot.
The bond market has also been unnerved by the announced intention of setting MSP at 50% higher than cost of produce for the crop. However, there are quite a few caveats here that one should remember. One, the finance minister said that this formula has already been applied for the Rabi MSP announcements made. While these MSPs were higher, they weren’t extra-ordinarily so. This then means that a similar magnitude should be expected in the Kharif crops for next season as well. This is demonstrated in the table below:
Two, MSPs influence prices for only a small minority of crops. Actual market prices may vary significantly from MSPs. This has been the case over the past year where some notable crop prices have been significantly below MSP. Thus what matters is that actual procurement should be significant and widespread. The Niti Ayog in consultation with state and central governments is to formulate a plan for this to happen, subsequent to which it may get implemented. This may take upwards of a year, a sense one got when hearing some of the views yesterday. Three, this hike may also be considered in the nature of a fiscal transfer where the government(s) bear the difference between MSP and market price as a means of supporting farmers. Therefore, even once the operation is fully functional, the entire hikes may not reflect in market prices. Fourth, the government is also on a mega-drive to link all APMCs via the e-NAM network. This may actually lead to intermediary margins coming off thereby compensating in end product prices for some eventual rise in farm level prices. All told then this is too early to react on the MSP news.
Going Forward
To us discussions with respect to RBI’s hawkishness are increasingly turning irrelevant. It is a given that the RBI will be hawkish. The question only is that, given underlying macros and the state of the economy, is it willing to go ahead and hike 75 bps over the course of the next year or so? If that is the case then the current level of bond yields may be justified. However, it would put current term spreads in close vicinity of the levels seen in 2013 when India had a full blown macro-crisis. Pretending that we have a macro-crisis when we don’t have one can eventually prove dangerous to broader financial stability as well. The central banker should take into account the fact that financial conditions, as denoted by market yields and liquidity, have already tightened considerably even as the economy itself is only just recovering from a prolonged downturn.
Our preference has been largely for front end rates (upto 5 – 6 years) where the element of rate hike pricing has been most extreme. This remains the dominant portion of our portfolio. However, we are increasingly also more inclined to tactically increase the ‘beta’ portion of the portfolio gradually. From an investors standpoint, while the level of pain recently has been almost unprecedented, it must be remembered that bond yields are beginning to stand out now from a stand point of cheapness of valuation.
Disclaimer:
MUTUAL FUND INVESTMENTS ARE SUBJECT TO MARKET RISKS, READ ALL SCHEME RELATED DOCUMENTS CAREFULLY
The Disclosures of opinions/in house views/strategy incorporated herein is provided solely to enhance the transparency about the investment strategy / theme of the Scheme and should not be treated as endorsement of the views / opinions or as an investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document has been prepared on the basis of information, which is already available in publicly accessible media or developed through analysis of IDFC Mutual Fund. The information/ views / opinions provided is for informative purpose only and may have ceased to be current by the time it may reach the recipient, which should be taken into account before interpreting this document. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision and the stocks may or may not continue to form part of the scheme’s portfolio in future. The decision of the Investment Manager may not always be profitable; as such decisions are based on the prevailing market conditions and the understanding of the Investment Manager. Actual market movements may vary from the anticipated trends. This information is subject to change without any prior notice. The Company reserves the right to make modifications and alterations to this statement as may be required from time to time. Neither IDFC Mutual Fund / IDFC AMC Trustee Co. Ltd./ IDFC Asset Management Co. Ltd nor IDFC, its Directors or representatives shall be liable for any damages whether direct or indirect, incidental, punitive special or consequential including lost revenue or lost profits that may arise from or in connection with the use of the information.