There are three large macro questions of note today, in our view:
- How far and how long on major Developed Market (DM) policy rates?
- How successful will China be to stimulate its economy?
- What about the weather?
A Concurrent Assessment of the Three Questions
DM rates are poised to be higher for longer even as they may be approaching the top. Growth generally has held up better than previously expected and while disinflation is headed in the right direction, it still is progressing at a painfully slow speed. While bank lending conditions have tightened, market financial conditions if anything have loosened further. Central bank forecasts see inflation falling but relatively gradually and only approaching targets by 2025 or so. This still allows for some rate cuts over 2024 in order to adjust ‘real’ policy rates to falling inflation. Nevertheless, the higher for longer narrative is now reasonably entrenched into market pricing as well. As an example, market expected pricing of Fed funds rate in January 2024 has moved up by approximately 100 bps in just over a month and currently stands at around 5.10%. It is stating the obvious to say that the longer DM rates remain elevated the more cash is considered a serious asset class in a global allocation portfolio. This means that the threshold return expectations for every other asset class goes up, adjusted for the risk embedded in them (since cash allocation practically carries no risk). Ceteris paribus, this also means that emerging markets (EMs) have to continue with a razor-sharp focus on ensuring macro-economic stability since global capital is likely to be that much ‘fussier’ in making allocation decisions given the context.
A greatly anticipated ‘reflation’ event for this year was China’s reopening. This was expected to meaningfully add to global demand and provide an important counterbalance to the slowing DM world. Commodity prices had firmed up in this anticipation while Chinese bond yields had risen. Analysts everywhere had marked up GDP growth estimates. However, the actual evolution has progressed somewhat differently. The drag on the real estate sector, and by extension on investments generally, seems to be deeper engrained than was being appreciated before. Thus even as the service sector has come roaring back, the same cannot be said about other parts of China’s economy. Policy makers also seem to be judicious in approach, preferring to avoid any big-bang measures presumably wanting to avoid the after-effects down the line. As a result there has been a general unwind in commodity prices, a rally in China government bonds, and a marking down of GDP estimates. In short, the reflation trade has been significantly unwound. This has helped inflation almost everywhere but has been particularly beneficial for net commodity importers like India, since it has helped with the external account as well.
Finally, and a point of evolving anxiety, the weather. Agricultural commodities are already starting to fret the dreaded ‘El Nino’. Monsoons in India have started on a weak note which, as per media reports, has already started to impact prices of certain kitchen staples; given the delay in kharif crop sowing. To be sure, there are various offsets to consider: IMD still predicts normal rainfall, and even in the event of some shortage here the implication for food inflation may still not be meaningful. Historic evidence of El Nino years is mixed as far as rise in food prices is considered. Pre-monsoon rains have been strong, buffer stocks are in better shape, the option of imports is more viable than it was last year, and the government has demonstrated time and again its proactiveness in managing the supply side. However, this still means that we are in a wait-and-watch mode on food inflation, and that RBI is justified in thinking about possible pressure on inflation during second half of the year.
An Actionable Framework
As the assessment above suggests, one is open to a wide range of possibilities just in the way these three open questions progress, and even without considering any other variables in the analysis. However, the task at hand (portfolio strategy) requires us to arrive at a most probable combination that yields an actionable. We proceed with that objective in mind. The most obvious question then is: Why not be in cash and wait out the evolution of uncertainties? In order to answer this question, one has to assess the following: 1> What is the most likely narrative one is pursuing? 2> What is the anticipated cost of pursuing the narrative; that is to say whether the costs can overwhelm the benefits?
In our view, the narrative is that we are at a mature stage of the current cycle. This is no revelation since many people are thinking the same way, but nevertheless requires due consideration. Also to be fair, the cycle seems different for different economies. The largest and second largest ones are at two ends of a spectrum, one wanting to slowdown and the other wanting to accelerate. Nevertheless, and at the risk of painting everything with a large and unwieldy brush, we refer here to a global growth cycle and counter-cycle. While the peak of global growth was already sometime back, it still pretty much feels like the pro-cycle phase as far as the general narratives on growth and inflation are concerned. That is to say, there is still extrapolation of recent trends with momentum adjustments on the margin rather than serious talks of an inflexion point, which is where a cycle becomes a counter-cycle. The reasons why this is so are all sound: US fiscal transfers have held up longer for the consumer, and central banks’ balance sheet shrinkage has had notable episodes of reversal which has served to loosen financial conditions. And yet we have been through one of the most aggressive DM rate hike cycles on recent record, large central banks’ balance sheets will still be shrinking over time, and the commodity pack is signaling that all is not well in the world. As the recent episodes in US and Europe banking have demonstrated, with this kind of a rate cycle things don’t break until they do. Whether the pieces get shoved under the carpet only to be possibly revealed again at a future indeterminate date is another matter. Even aside from a sudden deflationary shock, at some point the influence of interest rates on aggregate demand should start to become clearer even after adjusting for the strength of DM consumer’s balance sheet from the extra-ordinarily large pandemic fiscal stimuli. All told then, portfolio positioning should be looking for the pro-growth phase in the current cycle to start to transition out, in our view. This strongly argues for an overweight on quality fixed income.
The other point to ponder is what is the cost associated in waiting for the narrative to change? As has been shown in the last few months, the ongoing narrative can be persistently sticky with the inflexion always appearing at the unreachable horizon. Given that our yield curve is positive sloping, the carry on bond investments is better than that earned from the overnight rate. So then the cost of waiting has to be addressed in terms of volatility; specifically in terms of the likelihood that the additional carry offered by bonds can be realized over a reasonable investment horizon. We have debated this point extensively in our post policy note (https://bandhanmutual.com/article/13183 ). Without going into all the nuances discussed there, given India’s notable improvement on both inflation and current account, it is to be noted that bond market volatility has become quite manageable. Offshore volatility is no longer transmitting to the extent it was last year and while rate cut expectations are being pushed out here as well, most of the market is comfortable with the idea that the policy rate hike cycle has peaked out. Thus as at date the cost of waiting seems quite controlled and the fundamental premise of positive carry amidst not very large volatility is getting met. As discussed in the post policy note, however, duration and credit risks have to be managed in a way that the objective is optimized.
Conclusion
We have had a series of false dawns so far in market calling the top of the cycle. While there is broad alignment again that we are approaching the end, one is still faced with a range of outcomes. The discussion above is sufficient to highlight this fact. At the same time, one needs to distill one’s thinking into a set of actions in a portfolio context. For this there are certain placeholders that need to be quantified. For us these are 1> late stage cycle that argues for overweight quality fixed income 2> domestic bond market volatility now manageable enough to be able to hold on to positions. Incoming information has to then be processed in terms of positive or negative impact to these placeholders and to what extent and with what durability.
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