Fixed Income Outlook for 2017 Investing in uncertain times

Birla Sun Life Asset Management Company Limited

January 2017

From the CEO First of all, a hearty welcome to 2017. This year has a lot in store for the investors, thanks to all that has happened in 2016. Despite the current market uncertainty, I sincerely believe that key happenings and initiatives like - a good monsoon, the Demonetisation drive, etc. have paved the road ahead for the Indian economy to bounce back stronger, than ever before. Demonetisation, in particular has and will prove advantageous for the Indian markets. This move has Mr. A Balasubramanian Chief Executive Officer - BSLAMC

completely changed the way India functioned all these years, as now black money has reduced significantly and is becoming a part of the main economy. The Banking industry has also gained a lot from it, as there has been a significant increase in deposits and bank balances of customers. Due to reduced disparities in

economy, banks have also started to lower the lending rates. The initial slowdown in economy due to demonetisation will soon be forgotten with an early budget and upcoming elections. I hope you enjoy going through the yearly Outlook. For your investment, you may consider investing in fixed income schemes where there is a falling interest rate for Traditional instruments and also hybrid funds. Apart from the above , equity assets can be built through SIP or STP. Happy investing.

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About our Co-CIO-Fixed Income As Co-Chief Investment Officer, Maneesh Dangi spearheads Fixed Income Investments at BSLAMC. He works closely with a team of three fund managers and eight analysts. With over 16 years of experience in fund and investment management, Maneesh has the distinction of managing one of the largest Asset Under Management in the Fixed Income segment (as on 31st December, 2016). Mr. Maneesh Dangi, Co-CIO-Fixed Income - BSLAMC

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Rates have been falling over the past three years. The current 10-year bond is 1 standard deviation below the mean compared to that of the previous two decades. As rates have been mean reverting, conventional wisdom would suggest that one should start to realign the portfolio to the shorter end of the curve by exploiting carry instead of relying on duration strategies. But current macro-economic conditions suggest that there may be some more steam left in the rate markets. We expect bonds to rally further in the coming months. Many market participants have presented the case for an end of the rate easing cycle and pared their bond positions. Are we really close to terminal repo rate?

How does an end of the cycle look? Generally, rate rally ends when there are signs of growth recovery. Monetary policy may still remain in an accommodative mode but bonds sell off as they sight turn in the growth cycle. Yield curves steepen. Liquidity premia don’t widen in the shorter end as monetary policy keeps liquidity in an easy mode. Banking system is generally in stress but begins to see some improvement. Credit is generally slow, but one starts to see pickup in activity levels. The mood of the consumer is still sombre but sentiments are recovering. Investment activity remains sluggish, but most of the balance sheet deleveraging has been undertaken.

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Is this an end to the cycle? Until the beginning of November, India was seeing mixed signs with respect to the advancement of the business cycle. There were hints that the business cycle may be just beginning to turn around. Banking and the corporate balance sheet were beginning to repair. Capex remained slow but one started to see signs of investment recovery. Earnings growth had struggled, but there were signs of a turnaround. But the gloomy mood among investors, weak credit demand, low capacity utilization and inflation near decadal lows pointed at a sluggish recovery. Bond funds had outperformed equity indices for more than two years, again a sign that the rate cycle may be overextended and faster economic growth may be round the corner. There were some signs of advanced if not a stretched cycle. Growth bottomed in 2013 and it is the third year of expansion. We saw Indian consumers being quite optimistic. Personal loans, particularly those in the mortgage segment, were growing at two times the rate of nominal GDP growth for more than two years. Even small cap/mid cap equities which are generally good indicators of the cycle’s advances, were exuberant. Though, bond funds made more money, personal savings were moving into a riskier asset class i.e. equities. Record money pouring into equity funds is one of the key reasons that is driving mid-cap stocks to rally. Flow of retail money is a better indicator of the cycle than the asset class’ performance. So both, the Indian consumer and saver were quite optimistic about the future of the country which is generally a sign of an expanding and overheating economy. So what was it, a cycle reaching the peak or just a long due turnaround? We started to recalibrate our duration positions across the funds as the probability of an end of the rate easing cycle rose over the past 3-6 months. We also seeded more carry across our funds to benefit from higher liquidity premia that are available in reasonable credits. Rarely, do all the Birla Sun Life Asset Management Company Limited

indicators come together to give a coherent view of a business cycle but our recalibration view was based on a probabilistic model. At that point in time, one could have waited for the end of 2017 to finally understand the inflection point of the business cycle. But then, November 8th 2016 marked a historic event in India’s socio-economic history. Here comes demonetization : The overall impact of withdrawing such a large amount of high denomination currency notes from circulation is likely to be large and long lasting. We are all trying to assess the long term repercussions of this move. In our assessment, there is a threefold impact of this on growth because of the cash crunch, the dampening of the sentiments and the wealth destruction effect. I think its impact driven by cash shortage will not last for long and it is likely that the cash crunch driven activity slowdown vanishes by Q1/Q2 CY 2017.This is when adequate ‘remonetization’ happens. But, until then, both the lower velocity and total supply of cash would continue to hurt the economy. Its impact on banking balance sheets could be durably adverse as many small and medium enterprises struggle, leading to higher NPAs for banks. Remember that banking balance sheets are already bruised and have very little cushion to accommodate further stress. This can delay the much needed credit recovery. Many argue that excess deposits will help them lower rates leading to higher credit growth. My view, au contraire is that it is the creditworthiness of businesses which drives credit growth and therefore credit pickup would be not easy to come by. I have travelled to various parts of the country since demonetization and I hear a near uniform view on property prices - that they are set to fall. This consensus view may postpone recovery in the already anaemic construction activity. According to Birla Sun Life Asset Management Company Limited

me, this sector is the fulcrum of local growth. I also fear that many financiers would tighten lending standards for products such as loan against property which reduces access to financing for small businesses further. I can only hope that a new cycle of NPA is not initiated due to these actions. I am not certain whether property prices will fall by 10-20%, as speculated by many, but I am almost certain that if they do so, this alone can design a slowdown in our country. There are very few instances in the world when such a steep fall in property prices has not predicated an outright recession. I am definitely not calling out a recession in India, but simply highlighting the importance of property prices for consumer and investors’ confidence and economic growth. While I am also in a dilemma on how deep the scars due to demonetization will be, I don’t agree with the cheerleaders who think India would simply move on barely affected by this. There are many social and moral benefits of demonetization. Also, one may argue that there may be many long term economic benefits. But, I am almost certain that in the short run it slows the economy. Because economic conditions were not encouraging, especially for small balance sheets and the banking sector at large right before the move, the effects of demonetization may hurt us badly. This would happen unless policy makers floor the problem. Also, the political narrative in India is starting to shift from development to anti-graft. I think, eliminating corruption would most likely be the central theme of the 2019 general election. While the 2014 campaign was about the government’s involvement in corruption, 2019 would be centered on the government’s action against it. UP elections will show how potent this theme is for the incumbent. I anticipate it to be a very important issue in the upcoming elections. I also think that if the government keeps itself busy in gaining anti-graft credentials while controlling inflation, the near term growth slowdown that I am expecting could get further stretched. Birla Sun Life Asset Management Company Limited

What will policy makers do now? For a strangulated economy, there are many standard templates to rely upon. One can depreciate the currency to export away the problem, increase the deficit funding to take up the slack or ease rates to help participants leverage. Given that exports aren’t the pivot of our growth, the options for us are either fiscal or monetary ones. Infact, policy makers in India are seen protecting our currency quite zealously even in the last 2-3 months. This saw a confluence of factors such as the EM sell off, USD appreciation, unabated outflows in both local bonds and equity markets and most importantly large FCNR redemptions. Our currency remained well behaved and depreciated a lot less than many of our EM counterparts because the RBI remained a continuous supplier of USD in times of stress. So will there be a Fiscal binge? Since budget will be presented in just about a month, it is unlikely that enough data would be available to hint at any significant slowdown. More importantly, thus far, policy makers have shown very little worry of durable slowdown due to demonetization. Fiscal response, though a better one is generally used after lots of deliberation, especially for a fiscal rule bound economy. Given our recent adherence to such a framework and the orthodoxy surrounding it, it is quite unlikely that budget would pave way for deficit financing led boost to growth. Also, from a timing standpoint, going all out via fiscal route could potentially be a powerful bullet for the FY19 budget. So, I assign a low probability of any significant fiscal impulse in the upcoming budget. My base case for fiscal deficit for FY18 is 3.25% of GDP with risks evenly balanced around it, in the range of 3-3.5% of GDP.

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And Monetary policy? So, the only option left for our policy makers is to use monetary policy to floor the problem. The good news is that the standard template of monetary policy framework gives space for significant rate cuts. Our base case is that CPI inflation (excluding allowance impact) is likely to average between 4-4.5% for FY18. It is surprising why RBI chose to forecast inflation for Q4FY17 at 5%+ whereas the likely outcome could be a lot closer to 4.25%. Most of the recent inflation decline has been due to fall in the prices of perishables and pulses. Our base case is that most of the decline rolls over and come FY18 (do you think it will take that long?), more durable impact of demonetization on housing sector and services economy may start to nudge core inflation lower. Purely looking at local growth and inflation conditions, an appropriate real rate may be just about 1%, thus terminal repo rate looks close to 5.25%.The bad news for us is that pure local conditions seldom determine policy bias. Given the risks from commodities for inflation and the actions of global central bankers for real rate, a more comprehensive view of the macroeconomic landscape for rates is warranted. Will global commodities be a risk to our inflation? It is important to note that commodity complex has shown strength in the last 6-9 months. The Trump rhetoric has also been a driver of this recent rise in the commodity prices, but most of the non-oil commodities have climbed down since Trump’s election. USA consumes 7 times less copper and other metals as compared with China. Recently, China has again driven commodity prices higher though the Birla Sun Life Asset Management Company Limited

magnitude of the rally in industrial metals defies fundamentals. Chinese reflationary policies are being unwound to some extent as its overbuilt economy (RE/Infra boom) has little room to reflate. Other EMs too, are likely to see capex slowdown. Thus, any positive impulse in US and Europe will likely get offset by slowdown in other EMs and China. I have been bearish on commodities for the past couple of years. Investment and real estate which consumes a big chunk of the non-oil commodities produced has been slowing across the globe. I think, commodities will only rise meaningfully when India starts to move the world demand. In my opinion, this theme will not gain potency before the next 5-10 years. My analyst team is working with the assumption of stagnant non-oil commodities, though we aren’t ruling out a retrenchment, given the recent sharp rise in their prices. As for oil, demand conditions have revived and slack has been artificially removed due to OPEC’s production cuts (near 2m b/d production cuts, recently). But most of this is already in price and given the expectation of rise in shale oil production, we think oil gains would be capped. Our base case on oil is in the range of $50-$60 for the year 2017. Thus, the upside risk to inflation due to commodity prices remainas low, though most of the disinflation due to lower commodity prices is surely behind us. Risk of USD tightening: While local conditions remain apt to deliver substantial rate easing, risks emanating from global economy are substantial. The most widely sighted risk is that of Fed tightening. Market’s consensus is of 2 hikes in 2017 (against Fed’s own dot plots of 3) and if the Fed delivers per expectations, we see little risk of big sell-off in treasuries. But as animal spirit rise in the USA, labor markets tighten and wage pressures

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accelerate, bond yields can harden further. Though most of the deflationary fears are behind us, markets haven’t moved on to expect meaningful rise in inflation in the USA. Sustained rise in USD would tame US inflation and will likely keep a lid on the risk of more than expected Fed tightening. But I am cognizant of the risk that tight dollar presents to the domestic rate cycle, though our reaction function isn’t as clearly established as it was in 2011-13 when we ran a substantial CAD. Fed tightening is a bad omen for both rate and risk assets in emerging markets. EM local currency bonds haven’t widened much vis-a-vis USTs. As EM bonds benefitted substantially from the carry trade in the past several years, a significant increase in UST will mean a death knell for EM bonds. However, it should be highlighted that ownership of Indian debt securities by foreign portfolio investors is minimal as compared to the outstanding stock. Many people worry about China’s inflation too, as various measures of their local inflation have been rising, but as their currency has depreciated rapidly, China is still exporting deflation. So in such circumstances, when the Fed is tightening and China and other central bankers aren’t in a loosening mode, could India deliver substantial rate easing? I am certain that rate cuts could have been easy and aggressive in India had this risk not been there. But even with this risk, I think, outside the times of rapid EM sell off and consequent rise in USD, the policy room will be used up by our policy makers. But investors must know that the ongoing sell off in global bonds and USD tightness remains the single biggest risk to India’s bond bulls. Purely from a positioning standpoint, bonds appear oversold across geographies. It’s almost a consensus trade to sell

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bonds. Even strong USD is 2.5 years old (since mid-2014) and trade appears over-extended. The theme ‘Rates are too low and must rise’ have had rhythmic frequency over the past few years but bond yields have refused to settle higher durably. The bond bear’s ‘This time it is different’ trade must be tested more rigorously before it is believed and traded. So what should investors do? Unless someone has a strong view on USD rising further, it is likely that bonds in India could deliver good returns. At 5.25%-5.5% of terminal repo rate with abundant liquidity in the system, bonds can easily breach 6%. But one must know that the bond rally in India is playing out in a not-so-benign world. During 2011-14, when most of the world bonds were rallying, our bonds behaved very differently as we saw sequentially high inflation prints and a sticky CAD. As our growth slowdown extends, aggressive rate response may come in. This would benefit the owners of duration in the fixed income markets. Markets may remain extremely volatile and investors should be patient in responding to such markets. Carry bets remain relatively less risky as they seem unaffected by global flows and are likely to behave like liquidity trades. Standard AAAs may go through a roller coaster ride as foreigners recalibrate their positions in distress. Also, it is likely that investors receive poor returns in other asset classes particularly property and fixed deposits. I have been bearish on the property market for the past 4 years. This bearishness is likely to persist for a few more years until inventory hangover diminishes across the country. Though affordability matrices are looking the best since 2009, most of the fundamental indicators such as rental yield/bond yields, per square feet price/per capita income and suchlike are still flashing red. In this backdrop, it is quite likely that property underperforms financial assets over the next few years. Similarly, Bank FDs which dominate an Indian’s wallet share may not deliver as banks’ incentive to raise money through term Birla Sun Life Asset Management Company Limited

deposits diminishes, given the deposit influx post demonetization and a weak credit environment on the other side. Much of this money will chase alternate financial assets such as fixed income funds. Also, it’s likely that most of the money will come in credit/carry funds as they seem to offer a stable return profile. For the past three years, duration funds haven’t got money though they have been the best performers. It may very well be the fourth year of a similar trend. While deciding asset allocation in such a volatile time, investors should look at fixed income funds. Both, carry and duration are likely to deliver good returns versus fixed deposits and FMP like products. Volatility fearing investors should hide behind carry but some allocation to duration could yield alpha to one’s returns.

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