The post Global Financial Crisis (GFC) world has often been criticized for the financial repression that it brought for the saver, at the benefit of the asset owner. This was especially true in the developed world given the years of zero or even negative interest rates that savers in many geographies had to contend with. It is quite likely, however, that there is no end in sight for this in the post Covid world as well. Indeed, repression as defined as the fixed real return on savings may actually get worse over the next few years. This is especially true again of the developed world where either the starting points on current account deficits is sanguine or else the ability to run a large and sustained such deficit for longer is stronger by virtue of the privilege of owning one of the reserve currencies of the world. Take for example, the case of the US. The Federal Reserve is actively endorsing an ever increasing fiscal package thereby effectively underwriting the large swathes of new public debt that are thereby getting created. This is a break from most instances in the past where central banks have normally pushed against excess fiscal expansions. Of course, the context here is different and arguably once-in-a-lifetime. One is thus not critiquing the move but merely making an observation. When a de-facto nominal yield control is combined with the likely view that the Fed is willing to let inflation run “hot” for a while to compensate for earlier undershoots (whether inflation actually runs hot is another matter), it is evident that US real yields are likely to be even lower in the post Covid world than in the pre-Covid, post GFC era.
It is to be noted that cyclically speaking it is perfectly logical to depress return to the saver to incentivize consumption and investments. This is because, again cyclically, the economic imperative is to boost consumption and investments. However, the argument at least for many developed markets may threaten to stretch for longer than just in the very near term. Given that it may take years for the current growth draw-down to get reversed and for economies to get back to positive and sustained growth trajectories, the argument for medium term savers’ repression is tempting to make for emerging markets like India as well. However, there is a critical difference here: 1> We don’t print a reserve currency of the world which will always pull global capital 2> Our current account deficit is cyclically depressed but will come back as growth starts to revive. Hence at some juncture in the future India will have to start to worry about adequate compensation to its savers, for fear of repeating the 2013 disaster.
The Twin Features of Post Covid Markets
Indian fixed income markets will likely continue to exhibit two pronounced features for the foreseeable future. These are manifestations ultimately of the new realities of public debt as well as heightened fragilities in the financial system.
1. Steeper yield curves: Policy rates are depressed and likely to remain so for some time. This is backed by surplus liquidity which keeps the effective overnight rate even lower. Thus the “carry versus duration” tradeoff is very lucrative at the short end but gets weaker as one moves up the curve. Additionally, while the RBI may be underwriting the government borrowing program for this year (admittedly somewhat silently so far but still quite effectively), funding uncertainties may rise in the years ahead. This also argues for higher term premium for longer maturities. For these reasons it is only logical for yield curves to be steeper.
2. Higher credit spreads: Our financial system was already marked by high levels of general bank non performing assets. Furthermore, there was a section of non-bank lenders who had been struggling since 2018. On top of this now comes an unprecedented nominal growth shock that will inevitably lead to fresh accretion of substantial stress in the system. Importantly, owing to this being a developing narrative and partly because of on-going dispensations, it is very difficult to make even reasonably accurate assessments of balance sheets and businesses. Combine the two and it is not surprising that investors should want much higher risk premia for companies where the starting strength of business is not unequivocally resounding. In fact, and quite logically, many companies are facing a very steep borrowing curve where the differential with the bluest chip issuers is not meaningful for short term borrowing but the gap rises meaningfully as the borrowing tenor increases. These are relatively sound names where investors are surer of the status in the near term, but the uncertainty escalates as one tries to peer farther into the future.
How Do You Want to Play?
Thus the current financial system is marked by the following: 1> Very low risk free / high quality short end rates. 2> Steeper curves and higher credit spreads tempting investors looking for added returns. As we have tried to establish above, there is a reason this is so. From an investor’s standpoint, the framework to be applied can be summarized under the following heads in our view (that the framework below can be summarized as a neat “AAA” acronym is purely coincidental!)
1. Acknowledge: In our view, the most important things to respect here are the magnitude of this shock and the inability to fully assess it owing to the shock still being in play and the relative opacity of information coming through (both for micros and macros). This acknowledgement in turn clarifies the course of action. From a mindset standpoint one has to first make peace with the proposition that one is trying to do the best in what is otherwise a bad situation. Returns in safe (both from credit and duration standpoint) fixed income are clearly nothing to write home about anymore. True that spread over overnight rate even on front end rates (up to 3 – 4 year AAA corporate bonds for instance) look quite attractive compared with history. However, absolute returns on offer have progressively shrunk and have to be incrementally looked at from standpoint of saving opportunity loss (for example, receiving 2% spread over overnight rate in a front end quality bond is akin to saving Rs 2 of opportunity cost a year) rather than offering possibilities of any meaningful mark to market gains ahead.
2. Assess: It is unlikely that the environmental distress and uncertainties abate in a hurry. Thus one will still have to make one’s assessments in a relative data vacuum. The first behavioral aspect of this assessment is pinning down the trade-off between: 1> surviving through this hopefully temporary phase of financial repression with very modest returns in safe fixed income versus 2> over-extending on risk with potential to throw up more than
tolerable amounts of pain down the line. The second aspect is to truthfully evaluate whether one is actually buying into “mispriced” value, or falling for a convenient narrative since quality is no longer offering attractive absolute returns.
3. Act: The possible courses of action for the investor are: 1> Acknowledge that this is part of the new reality and ignore the temptation; that is remain in safe fixed income. 2> Play tactically either the steep curve or the higher credit spread or both. 3> Treat this as an opportunity and not a new normal and “lock” into either the higher term spreads or higher credit spreads on lower rated assets or both. As discussed above, we would caution against being too deterministic in such a highly volatile and evolving scenario. Hence for the most part it makes sense to bat straight and allocate conservatively, accepting the lower absolute returns for now but ensuring that one is alive to fight another day. One can even endorse tactical plays to some extent, provided there is reasonable clarity that these can be exited. For instance, we have tactically gone overweight on 9 – 14 year government bonds in our actively managed bond and gilt funds (after playing an overweight stance in 6 – 7 years since late May https://idfcmf.com/article/1984). However, this is subject to change on assessment as always and doesn’t necessarily reflect a medium term view that the yield curve is too steep. Such a view will have to await a better assessment of the financing position of the government over the next few years. Importantly, while the long duration play may be tactical for us it needn’t be so for the investor. From the investor’s standpoint some allocation to “satellite” strategies like active duration funds (that in turn take these tactical trades) could be part of core asset allocation.
A trickier maneuver, and one best avoidable in our view given the current situation, is to try a tactical trade in the lower rated credits market. Such positions are prone to sudden illiquidity and hence may end up trapping investors.
Summary and Conclusions
This is the second phase of global financial repression and is likely to be pronounced and sustained for developed markets. For countries like India, where long term financing needs are substantial, the saver will have to come into focus at some juncture. Meanwhile, investors are living with very low absolute yields on quality bonds with lower duration risk. Steep yield curves and wider credit risk premia are tempting avenues to increase returns. However, both these phenomena are logical pricing of the risks embedded in the system. Importantly, the magnitude of shock underway is unprecedented and the information available to assess its impact is thin. Therefore it is very critical that investors follow a logical framework for allocation and not get pushed into taking risks that are outside their realm of appetite and / or aren’t well thought out. Quite concerningly, we are seeing signs of this behavior. The assessment of risk has to be a function of the underlying narrative. Outside of agriculture, the macro narrative hasn’t changed discerningly for the better for the rest of the economy. And yet investors are pushing into diluted credits. This then seems largely driven by a collapse in quality rates rather than an improvement in the environment.
Instead we think one has to take a longer investment perspective. At various points in a growth cycle, the relative importance of savings versus consumption / investment keeps changing. We are currently at a point where the acute nature of the shock is making the trade-off very much against the saver. However, over the medium term this will likely normalize at least for developing markets like ours. Alternatively, the environment would relatively stabilize and data will become clearer allowing for a better assessment of risk when reaching for higher returns. In the meanwhile one has to live with this period in the least damaging way possible. In our view this is accepting lower returns for now rather than unnaturally expanding risk appetite. Tactical deviations, if at all, have to take into account the liquidity in the underlying asset class and have to balance the very real possibility of getting trapped outside of one’s risk appetite.
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