Aggressive rate cuts, limited transmission

By Morningstar Analysts |  04-10-19 | 
 

In its fourth bi-monthly meeting for FY 2019-20, RBI’s Monetary Policy Committee (MPC) decided to cut the policy repo rate by 25bps from 5.40 percent to 5.15%. Consequently, the reverse repo rate stands adjusted to 4.90%, and the marginal standing facility (MSF) rate and the Bank Rate to 5.40%. All members of the MPC voted unanimously to reduce the policy rate and to maintain an accommodative stance as long as it is necessary to revive growth, while ensuring inflation remains with the target. Five members voted in favor of 25bps cut and one-member voting to reduce the policy rate by 40bps.

RBI revised its inflation and growth forecasts. Headline inflation for Q2 2019-20 is revised upwards to 3.4 percent from 3.1% projected earlier, while H2 2019-20 projection is unchanged and is in the range of 3.5-3.7%, with risks evenly balanced. GDP growth for FY2019-20 is revised downwards from 6.9% in the August policy to 6.1%. For H2 2019-20, real GDP growth was earlier projected in the range 7.3-7.5%, which is now changed to 6.6-7.2 percent for H2, with risks evenly balanced.

 Our Take

Weak private demand and subdued investment activity have widened the output gap. Private expenditure grew at 3.1% in Q1 2019-20 (eighteen-quarter low) and gross fixed capital formation remained week, growing at 4% in Q1. Both urban and rural consumption demand remains weak as benign food inflation would keep farm incomes low, auto sales (including passenger and commercial vehicles) continue to witness contraction, and domestic air passenger traffic growth remains muted at 3.2% compared to last year’s 20% growth. The latest manufacturing PMI reading of 51.4 for September (unchanged from August) suggests subdued demand conditions. Services PMI reading of 48.7 is down from 52.4 in August due to contraction in new business intakes and output. On the other hand, bank credit to the service sector (+1.6%), personal loans (+1.2%), and priority sector (+0.2%) have witnessed only marginal month-on-month (August over July 2019) improvement. The recovery rates under the insolvency and bankruptcy code have improved to 40% from historical rate of around 20% during pre-IBC era. However, speedy resolution of stressed assets is needed to improve the credit flow. Recent woes in the credit markets particularly regarding NBFCs and HFCs have impacted their ability & willingness to lend to retail & corporate borrowers, contributing to the slowdown in consumption.

With today’s rate cut resulting in a cumulative cut of 135 bps, RBI might opt to wait for few months for the monetary and fiscal measures to transpire in to the real economy. The transmission of lower policy rates should happen quickly – which is significantly lacking at the moment. Banking system liquidity turned surplus from June 2019 on the back of measures taken by the RBI to provide liquidity support to NBFCs. This helped in effective transmission of rate cuts to money market segment. However, surplus liquidity has so far not translated into higher credit growth.

The corporate tax cuts announced last month, would help companies improve their margins and earnings. Although this may not lead to an immediate capex expansion activity as there are no strong signs of recovery in consumer demand, and companies would like to see some recovery before going ahead with capex. How much of tax cut benefit will be passed on to the consumers is questionable, and we will know more in the coming months. The move has boosted the market sentiment, though the bigger question of directly reviving slowing consumer demand is not yet answered, and we doubt the government has got any more fiscal room to announce measures in this financial year. The reduced tax rates to promote local manufacturing puts India in a preferable spot when compared to other Asian peers. This is expected to benefit India, with manufacturing gradually shifting away from China. Along with corporate tax cuts; further focus on improving ease of doing business, land and labour reforms, pick-up in government expenditures, and measures to increase the disposable income, are few essentials needed to revive the domestic growth.

To an extent, this rate cut was already factored in by the market as the participants were divided with an expectation of a 25bps or a 35bps cut in the policy rate. The yield on the 10-year benchmark G-sec rose by more than 25 bps in the last two months on concerns over fiscal slippage. Post policy announcement 10-year G-sec yield inched up 9bps, closing at 6.69%. Lower than anticipated tax collections with the economy slowing would ultimately increase government’s reliance on divestments, small savings, and to an extent on additional market borrowing – in case the government overshoots the fiscal target.

What do our Valuation Implied Return (VIRs) forecasts for fixed income indicate?

Based on our valuation-driven asset allocation approach, Medium-term debt offers a relatively attractive spread over the fair value estimates as compared to Short and Long-term debt within the Indian fixed income basket.

How have we positioned our Managed Portfolios?

Indian fixed income markets witnessed a sharp rally, with 10-year G-sec yield down by more than 100 bps from 7.42% in April 2019 to touching a low of 6.33% in July. With such a sharp rally at the longer end of the yield curve, we brought back our overweight position in Long-term Debt to benchmark or neutral level across all four portfolios in July 2019. With that, we continue to be overweight Short and Medium-term debt, amid attractive real rates. We are not proposing any other changes to the underlying holdings at this time, as we believe the composition of the Portfolios remains appropriate for the prevailing conditions. We continue to monitor the portfolios closely and stay focused on helping investors achieve their goals over the long term.

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