LAST CHANCE TO PROFIT FROM THE INTEREST RATE CYCLE

           

2008 crisis

With the collapse of Lehman Brothers, liquidity dried up, and so RBI cut repo rates severely – 9% to 3.5% in 6 months. Repo rates between Feb 2009 and May 2009 did not change, but the Government went in for some sort of quantitative easing and started spending and so without any changes in repo rates the yield went up to 6.5%. China went for investment stimulus and India went for consumption stimulus.- NEGRA, VIth Pay Commission, farmer loan waivers, excise duty cuts, etc. As there was no corresponding investment, there developed supply side constraints and the inflation pushed up. Current account deficit became a problem – India was borrowing from abroad to fund consumption.

3.50% repo rate bounded upto to 8.5% very fast. Exiting the 3 year interest rate hike cycles is not going to be easy. However going forward inflation will not lead to a rate hike by RBI, and ultimately there will be a rate fall. With a 5.5% growth rate,  RBI will have to do something to stimulate growth.

Current Situation:

RBI has been concentrating more on liquidity in the markets by reducing CRR by 25 bps in September, 2012.  There was an additional CRR cut by 25 bps in October, 2012.  Cash reserve ratio is the proportion of their deposits that they have to maintain in cash. They deposit this cash with the RBI. RBI uses CRR to drain excess liquidity or to release funds into the economy.

Growth is still very low. The June 2012 quarter GDP growth at 5.5% was slightly better than the March 2012 quarter growth. Growth was driven by Construction and services. The whole year’s growth is expected to be around 5-5.5%.

Exports declined 9.7% and dropped to $22 bn in August 2012 compared the normal range of $24-$25 bn per month. Trade deficit has therefore widened. The only positive was the slowing down of gold imports.

The tax revenues will be impacted due to the considerable slowdown in economic growth. There is also a grim outlook for budgeted receipts from disinvestment and telecom auctions. This would all adversely impact the fiscal deficit. The recent increase in diesel prices reduces the under recovery for diesel. The government has also confirmed that they will not be increasing their borrowings in the second half of this year.

Forex reserve at US$ 290.5 bn are at the same level of January 2008.  India’s import cover of 7-8 months is the lowest of the last decade. The average import cover for the last 10 years has been about 11.5 months. This is putting pressure on the rupee. To counter the rupee fall, RBI intervened in the forex market selling reserves of about $25 bn. However, the latest development on policy front has given some boost to the rupee. USD/INR will find it difficult to go below Rs. 53.

Credit growth has slowed down substantially. The biggest indicator of loan slowdown is the fact that both deposit and lending rates have been cut just at the start of the busy season on credit. This is a bullish trigger.

Persistent high inflation diminishes hopes of further rate cuts. Headline inflation in August 2012 came in at 7.55% versus 6.87% in July 2012. However, RBI has said that they may not actually wait of the inflation numbers to fall; so long as the momentum is in line with their expectations.

Debt Mutual Funds:

1.     Increased liquidity resulted in the short term rates falling sharply. Call market rates fell to below 8% and 1 year CD rates are currently at below 9%. Previously there was not much rate difference between the money market instruments and the longer term debt, but the rates at the shorter end of the interest rate curve has fallen substantially.

2.     Banks have front run the RBI by cutting interest rates. This is because of increased liquidity and banks are not looking at any credit growth. Interest rates are a based on demand and supply.

3.     There is has been a large demand for AAA rated paper and hence the interest rates have fallen by 25 bps and 40 bps. The 5 year AAA Corporate paper has fallen more than the 10 year paper.

4.     At some stage RBI is going to have to cut interest rates again to stimulate growth. However, without cutting interest rates the rates have been falling, because of increased liquidity and demand for paper to invest in.

5.     With the falling of short term interest rates, capital gains have already been earned in the short term debt funds. Thus short term rates are expected to remain within the range: 3 months CDs 8.4% to 8.65% and 1 year CDs 9.00% to 9.15%.

Hence going forward

1.     Hence need to look at debt funds of a longer duration currently. These could be more volatile, but with the inevitable cut of interest rates to stimulate growth as some stage, these funds would give 12%+ returns over the next year or so. Some longer term gilt allocation would be needed in the portfolio to give alpha.

2.    There is still a spread of about 1% between Corporate Bond funds and Government bonds. Hence these funds, with a longer duration, will be likely to give better returns – although the exit loads for these funds are longer – going upto 2.5 years.

3.    There is going to reinvestment risk, as the interest rates start falling. Hence at least 1/3^rd of the debt portfolio would need to be in 3 year  FMPs. This is because after you earn on falling interest rates, by getting capital gains – going forward where would you invest. Would not really currently be looking at longer FMPs as the interest rates have fallen so sharply, and by that time we might be in the next interest rate cycle.

4.     If you do not currently have any short term debt funds, although there has already been a run in the short end of the interest rate curve, a small amount can be kept for stability in your debt portfolio. Further these too should give double digit returns as the fall is not totally over.

5.     Although there are accrual debt products – i.e. they match the yields (less expense ratio) with the modified duration – hence the capital gains on these products are minimal, but in a falling interest rates scenario, they should give better returns than FMPs. A small part could be in this.

6.      Finally, you need to be prepared for volatility in the debt market. There is a huge amount of FMP funds to mature in the near future. As the one year FMP rates have fallen to about 8%, these funds are going into debt funds, and hence even demand for debt paper is going to be there in the near future

Triggers for a Gilt market rally:

-         Interest rate cuts

-         Open Market Operations

-         Supply and Demand – with all the FMP paper maturing and banks demanding gilts for the year end.

Hence, start investing in debt mutual funds with a long modified duration (and with some allocation to gilts) and also in Corporate Debt funds.

Fixed Deposit vs Debt Mutual Fund

1.     With a fixed deposit, you get interest and at the end of the term you get your capital back.

2.     With a debt funds, the yield would be about the same as a fixed deposit, but over and above there can be a capital gain, when the interest rate falls. (the reverse can happen with rising interest rates). We are currently in the rare situation where RBI has clearly announced that there will not currently be any rising interest rates.

3.     The tax treatment also makes debt mutual funds more attractive. Interest on FDs attract income tax at your tax rate. Dividends are tax free and the fund pays Dividend Distribution Tax of 13%.

4.     For longer term debt funds held over one year, capital gain tax would be payable. If inflation remains high, the tax would be nil (indexing benefit), and could go up to a maximum of 10% (without any indexing benefit. This is more attractive than the highest tax rate of 30%.

Budget 2012 – 2013

Overview of the Economy:
1. GDP is estimated to grow by 6.9% in 2011-12, after having grown at 8.4% in the preceding two years. For the Indian economy, recovery was interrupted this year due to the intensification of the debt crisis in the Euro zone, political turmoil in the Middle East, rise in crude prices and inflation.

2. With agriculture and services continuing to perform well, India’s slowdown can be attributed completely to slow down in industrial growth.

3. In 2012-13, India’s GDP growth is expected to be 7.6% +/- 0.25%.

4. Headline inflation is expected to moderate further in the next few months and remain stable thereafter.

5. The fiscal deficit was 4.8% of the GDP in 2010-11 (due to auction of 3G spectrum), down from 6.5% in 2009-10. The fiscal consolidation was expected to continue in 2011-12 with a budgeted fiscal deficit of 4.6% of the GDP. However, the actual deficit is estimated to be 5.9% of the GDP, due to slippages in direct tax revenue and increased subsidies.

6. The government has pledged to cut the fiscal deficit to 5.1% of GDP in the next year. The Net market borrowing by the Government to finance the deficit is estimated to be Rs. 4.79 lakh crores in 2012-13. Disinvestment target is Rs. 30,000 crores, with at least 51% ownership and management control to remain with the Government

7. Endeavor to keep central subsidies to under 2% of the GDP in 2012-13 and over the next 3 years reduce it to 1.75% of the GDP.


Key Focus Areas of the Budget:
1. Revival of Domestic Consumption
2. Achieve an Enabling Environment for Revival of High Growth
3. Remove Supply Bottlenecks
4. Intervene decisively to address Malnutrition
5. Expedite improvement in Delivery Systems and address Black Money

Legislative Reforms
1. The Direct Taxes Code was introduced in Parliament in August 2010. Report of Parliamentary Standing Committee has just been received. Will take steps for the enactment of DTC at the earliest.
2. Goods and Service Tax Bill was introduced in Parliament in March 2011. Awaiting the recommendations of the Parliamentary Standing Committee.
3. GST Network has been approved by the Empowered Committee of State Financial Ministers and will be set up as a National Information Utility and will become operational in August 2012. Use of PAN will be the common identifier in both Direct and Indirect Taxes.
4. There are 10 big-ticket bills and amendments to be moved in the Budget session.

Agriculture
1. Total planned outlay for the Department of Agriculture and Cooperation is being increased by 18% to Rs. 20,208 crores
2. Missions in the Twelfth Five Year Plan
(a) National Food Security Mission
(b) National Mission on Sustainable Agriculture
(c) National Mission on Oil Seeds and Oil Palm
(d) National Mission on Agricultural Extension and Technology
(e) National Horticulture Mission
3. Short Term Crop loans given to farmers at 7% will be continued in 2012-13.

Infrastructure Development
1. First Infrastructure Debt Fund with an initial size of Rs. 8000 crore launched this month to tap the overseas markets of long tenure pension and insurance funds.
2. Tax Free Bonds doubling to Rs. 60000 crores in 2012-13.
3. External Commercial Borrowings (ECB) funding allowed for Power, Aviation, Roads & Bridges, Ports & Shipyards, Affordable Housing, Fertilizer and Dams where Withholding tax has been reduced from 20% to 5% for three years.


Capital Markets
1. In 2011-12, FII limit was raised in long term infrastructure bonds, corporate bonds and government securities. The limit on ECB was raised and qualified foreign investors were allowed to invest in mutual funds and equities.
2. Now allowing Qualified Foreign Investors to access Indian Corporate Bond market
3. Simplifying the process of issuing IPOs
4. Providing wider shareholder participation through electronic voting.
5. Permitting two way fungibility in Indian Depository Receipts.
6. Restriction of Venture Capital Funds to invest only in nine specified sectors is removed.
7. It is also further proposed to remove the cascading effect of Dividend Distribution Tax in multi-tier corporate structure.
8. Propose to allow repatriation of dividend from foreign subsidiaries of Indian companies at a low tax rate of 15% as opposed to 30% for one more year.
9. Exemption of Capital Gains tax on sale of Residential property, if sale proceeds is used for subscription in equity of a manufacturing SME for purchase of new plant and machinery.


Tax Proposals
1. Direct Taxes
(a) Exemption limit for Direct taxes increased to Rs. 200,000 from Rs. 180,000.
(b) The upper limit of the 20% tax slab was been increased from Rs. 8 lacs to 10 lacs.
(c) Hence the exemption limit for Senior Citizens remains at Rs. 250,000 and the definition of senior citizen remains at 60 years.
(d) Further the exemption limit for Super Seniors, those about 80 years remain at Rs. 500,000

2. Individual tax payers will be allowed Rs. 10,000 for interest on saving bank deposits. This will allow small tax payers with salary income upto Rs. 5 lacs exemption from filing returns.

3. Within the limit for Health insurance, Rs. 5000 to be allowed for preventive health check up

4. Senior citizens, who do not have any business income, are exempt from paying advance tax.

5. Rajiv Gandhi Equity Saving Scheme will allow for income tax deduction of 50% to new retail investors, who invest upto Rs. 50,000 directly in equities and whose annual income is below Rs. 10 lacs. This scheme will have a lock in of 3 years (Hopefully it will be extended to Equity Mutual Funds too).

6. However, Infrastructure Bonds upto Rs. 20,000 may no longer be tax deductible, as this was applicable for just one year, and then extended for another year.

7. No change in the tax rates for Corporates.

8. Indirect Taxes
(a) Service Tax
i. On all services except those in the negative list, comprising of 17 heads.
ii. Service Tax is raised from 10% to 12%
(b) Securities Tansaction Tax reduced 20% to 0.1% for delivery transactions.
(c) Standard Rate of Excise Duty to be raised from10% to 12%, merit rate from 5% to 6%, and lower merit rate fro, 1% to 2%, with a few exceptions.
(d) Excise duty of large cars to be enhanced
(e) No change in proposed peak rate of customs duty of 10% on non-agricultural goods.



Hence based on the budget proposals the following are the outlooks in the equity and bond markets.

EQUITY MARKET OUTLOOK
1. Budget turned out to be a non-event for the equity markets with no major structural reforms
2. Budget proposes a law that could overturn the Supreme Court ruling in the Vodafone tax case. That is certain to shock foreign investors.
3. Not clear if the investment under Rajiv Gandhi Equity Saving Scheme would be applicable to only new retain investors who had not opened a demat account yet.
4. The markets are likely to be disappointed by the continued fiscal profligacy of the Government and lack of any credible plan for fiscal consolidation. Further oil price assumed in the budget was $115.
5. As the equity markets have already run up 20% this year, and the FII have invested bout $8 billion, hence we might witness some consolidation.
6. Market will watch out for incremental news flow on global economic development, movement in crude oil, political re-alignments and RBI’s policy moves.

BOND MARKET OUTLOOK
1. Net Borrowing of Rs. 4.79 lac crores is 10% higher than the current year, and this led to sell off in longer year bond yields. Going forward, due to the huge borrowing programme, there is going to be pressure on long term yields.
2. Expenditure estimates (except oil subsidy) seems more realistic leading to the belief that the numbers may not be revised too often. However there is no definite road map to curtail expenditure.
3. The short term spreads in the Bank CD’s and 1-3 year AAA bonds are likely to present interesting opportunities once the liquidity pressure unwinds.