Attractive returns despite interest rate uncertainties

Express Money
The year 2012 was a good one for investors in India, with most asset classes delivering strong returns. Equities were up 25 per cent over the year, most categories of fixed income funds too delivered returns in a range of 10-15 per cent and gold rose by 11.5 per cent. Meanwhile, the rupee reflected macro worries that engulfed India, losing around 3.5 per cent in value.

Unlike 2012, where domestic investors for a major part of the year were left to worry about India's vulnerable economic situation, 2013 has started off with a measured feeling of hope and optimism. The announcements of reforms in the last few months have been a big positive; however, the successful execution of these would drive sentiments and markets. In January, we again witnessed a string of actions from the government. In a decisive move to contain oil subsidy burden, the government announced a calibrated hike in retail diesel prices and one-shot hike in bulk consumer sales at market rates. Secondly, to control gold imports, the government announced a hike in import duty from 4 per cent to 6 per cent with immediate effect.

These measures are an attempt to lower risks from twin deficits — fiscal and current account, which clearly rank as top priorities for India's policy makers. The combination of cheaper credit as a result of lower interest rates coupled with a conducive policy environment is expected to kick start the domestic investment cycle and this should be well supported by foreign investment flows. Year to date, Indian equities rose by 3.0 per cent and bond yields declined around 16 basis points on expectations of lower interest rates. Moreover, rupee appreciated by 3.2 per cent against the US dollar in light of strong FII flows.

The year also started on a positive note globally. The macroeconomic and fiscal uncertainty, which dominated the global landscape for most of last year has declined in light of increased optimism. Financial markets saw a rise in prices of risky assets as concerns on sovereign debt crisis in Europe, US fiscal cliff and China's slowdown eased.

We believe 2013 will be a year of moderate global growth; however, some divergence will be seen at a country level with some experiencing recession and others growth.

Economic policies — monetary and fiscal — will be the catalysts for financial markets. With policy rates in major developed economies already close to zero levels, central banks are expected to remain in an expansionary mode. In the US, underlying economic indicators are improving. Signs of recovery in the housing market and positive earnings results have provided an impetus to financial markets.

However, the key risk to outlook in the near term is the uncertainty over fiscal policy. Although a last minute deal avoided significant budget cuts in January, there are still key issues to be addressed.

In Europe, ongoing austerity coupled with tight financial conditions, structural reforms and uncertainty could result in lower growth particularly in peripheral countries. Although bond yields in these countries have fallen sharply, domestic credit conditions remain quite strained. Meanwhile, Japan has re-entered recession. The new administration in the country has been aggressive on monetary policy. The Bank of Japan has committed to a new 2 per cent inflation target and announced a large asset purchase program. In China, after last year's slowdown, growth seems to have picked up and economic indicators suggest a mild rebound in economic growth. However, the upcoming leadership transition and restrictive property policies lend an uncertainty in the short term.

Coming back to India — In line with our expectations, the Reserve Bank of India lowered repo rate by 25 basis points, but somewhat surprisingly also lowered the cash reserve ratio by 25 basis points in its third quarter review of the monetary policy on January 29. However, more importantly, the central bank tempered market expectations of a series of rate cuts, by drawing attention to a range of factors other than just the wholesale price inflation which has moved lower over the past few months.

These include the still high levels of real wage growth, elevated levels of CPI particularly in the food component, as also high inflation expectations entrenched in the economy, and most importantly the high level of India's current account. We had already been of the view that markets were overpricing the stimulus from rate cuts, hence not too surprised by the slight negative reaction following the monetary policy.

Against this backdrop, the course of interest rate cuts over the year could be uneven. Nonetheless, we believe fixed income markets should perform well in 2013 with long bond/flexi bond funds delivering impressive returns. We also expect short term bond funds to perform well given their attractive risk adjusted return potential.

The author is Head – Fixed Income, L&T Investment Management

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