Don't expect an encore from gilt funds

How much further can the RBI cut rates given inflation and the current account deficit?

The last two years of protracted slowdown have now engulfed all segments of the economy, starting from industry and then spilling over to the services sector: 2012-13 registered the lowest growth rate in the last decade at 5 per cent and we expect growth at subdued levels even in 2013-14, around 5.5 per cent. On inflation, the good news is that headline Wholesale price Index (WPI) inflation has been on a downward trajectory and we expect it to average at around 5.5 per cent this year. The current account deficit (CAD), made an all-time high of 4.8 per cent 2012-13. However we expect CAD to decline to 3.5-4 per cent in 2013-14. This is anticipated on account of improvement in exports and the stringent measures undertaken by the policy makers to keep gold imports under check. Oil imports are also expected to fall as energy price deregulation corrects the artificially elevated domestic demand.

As inflation continues to moderate and CAD begins to recede, slowdown risks should weigh on the RBI’s policy decision and encourage it to shift its stance from anti inflation to pro growth, thus paving way for rate cuts. Based on this, we expect further repo cuts of 75 basis points in 2013-14. The recent weakening of the rupee would delay the rate easing cycle, but the underlying pain in the corporate balance sheets, and the mounting stress in the banking sector would ensure longevity of rate easing regime as it resumes after this short pause.

If the fiscal deficit target is missed, would that impact the RBI’s rate action?

The Finance Ministry unleashed a series of tough but much needed reforms and achieved fiscal deficit of 4.9 per cent for 2012-13. A target of 4.8 per cent was set for 2013-14. Given this scheme of things, fiscal risks seem to have mitigated. As RBI itself is cognizant of this, we don’t see fiscal deficit acting as a major hindrance to monetary policy easing. That said, given that it’s a pre-election year, we do assign a low but meaningful probability to some sort of populist measures being rolled out by the government which may toss the fiscal deficit off its anticipated path. In the event that happens, the RBI may consider a halt.

How long will the declining interest rate regime last this time around?

We expect rate cuts to continue beyond 2013-14, well into the next fiscal. We expect terminal repo rate to be 6 per cent, by the end of the rate cycle. Our belief about the durability of the rate easing cycle stems from an extensive analysis of the banking sector balance sheets and the credit situation in the economy. Banking balance sheets have begun to increasingly resemble the 2001 to 2003 period, with Gross NPAs and restructured assets touching close to 9 per cent. These have a significant bearing on the future earnings of these banks, due to higher provisioning requirements. Banks, already starved for capital, will be increasingly constrained to pursue the credit demands of industry crippled by slowdown. This would ensure the longevity of the rate cutting cycle, somewhat like 2001-03 when the RBI had ensured a low rate regime to stimulate investment.

Income and gilt funds delivered close to 14-16 per cent return in the last one year. After the sharp decline in 10-year G-Sec yields in the month of May, yields spiked by 25 basis points. How much of upside is left in the bond market?

Yes, the bond yields fell rapidly in May, but the recent episode of sporadic outflows has left the markets disturbed and further softening of rates once again is delayed. This recent currency depreciation on account of emerging market fund outflows has only delayed the rate cuts and not eliminated them. In fact, in our view there is much more upside left to the long trade today, than what existed prior to this event.

Within debt funds, can investors stay invested in long-term gilt funds, or consider shifting to income and dynamic funds?

For a longer time horizon, investors should choose income funds over gilt funds as they give a higher degree of freedom to the fund manager who can trade spreads too in such funds. For a shorter term, investors should look at investing in short-term bond funds, replacing liquid and short-term fixed deposits, to hedge the reinvestment risks.