After a year of policy normalisation, it is time to withstand volatility
For those who are not familiar with Murphy's Law, it is a popular cultural adage regarding misfortune in general. It is typically stated as: "Anything that can go wrong will go wrong." It is also often extended to "Anything that can go wrong will go wrong, and at the worst possible time."
Murphy’s Law was named after Captain Edward A. Murphy, a US Air Force engineer who was working on a project to see how much deceleration a person could withstand in a crash.
Inspired by this theory, Peter Drucker, the great management consultant, formulated Drucker's Law to deal with the complexity of management. Drucker’s law states that: "If one thing goes wrong, everything else will, and at the same time."
At the same time last year, vaccines and their rollout was the most pressing problem for the world. It was expected that with the pace of vaccination roll-out picking up, supply chains would normalise and inflation would come down. In the world of monetary policy, it was widely anticipated that policy normalisation would be gradual.
However, as the year went on, most of these predictions failed to come true. The global economy, coming on the heels of once-in-a-century pandemic, faced a concoction of high inflation, unexpected geo-political shocks, aggressive monetary policy normalisation and rigorous Covid restrictions in China. There were around 275 rate hikes in 2022, enough for one every trading day, with more than 50 central banks having executed the once-rare 75 basis-point increase (Source: http://bit.ly/3idFCxD).
The RBI also had to hike its policy rates by 290bps during FYTD23 from a lower bound of 3.35% to 6.25% in a short span after guiding a calibrated policy normalisation in February 2022. This was done post the geopolitical-led commodity shock and aggressive monetary policy actions from the advanced economy central banks.
Investors who were waiting for better entry points — despite the aggressive monetary action, decline in systemic liquidity and the lack of RBI OMOs, the Rs. 14 trillion plus gross government borrowing (compared to pre-Covid gross borrowing of Rs. 9.3 lakh cr in FY20) — sailed smoothly. The 10-year benchmark bond yield closed just seven times over 7.50% throughout 2022 (Source: Bloomberg). This was despite the non-inclusion of India in global bond indices. Long-end government bonds also remained well anchored, thanks to much lower than announced state government borrowing.
As we get closer to the terminal policy rate, the MPC meetings have started to witness a growing divergence between members regarding terminal policy rates, monetary policy stance and members’ outlook on growth and inflation. While some members have characterised growth outlook as “fragile” and are perceiving local and global inflation to have peaked, majority of members remain concerned on sticky core inflation and wish to maintain policy action to bring inflation closer to the target of 4% in the medium term.
As we had noted in our April ‘22 MPC review (The RBI pivots: Update on the Monetary Policy (utimf.com), given the long prevalence of headline CPI over 6% in a supply shocked global economy, which RBI did not really have a control on, a logical thing for RBI would be to anchor inflation expectations towards 4%, by providing a reasonable real rate buffer till it is closer to its 4% target. Hence, we do not expect RBI to provide monetary support in case of a moderate slowdown in domestic growth.
Outlook: Improved valuations; Curve broadly priced towards the expected terminal rate
We believe markets will remain range-bound in the near term till global central banks sincerely pivot i.e., start cutting rates, which may turn the risk sentiment. However, that is still some time away as central banks await meaningful decline in inflation, increase in unemployment or an inadvertent crisis.
The two pandemic years of 2020 and 2021 were characterised by low interest rates, exceptionally high liquidity and reasonably steep yield curves. This provided acceptable compensation for holding longer duration. The year of policy normalisation — 2022 — was largely a period of repricing of bond yields, subpar returns and flattening of the yield curve.
The tough act for investors today is to position and ride out the volatility, given the wide distribution of possible outcomes with intermittent false flags on inflation, geo-political dynamics or financial stability.
The current market valuations after the meaningful corrections, especially on the one-to- three-year segment of the yield curve, are broadly in line with their long-term averages and pricing in the consensus RBI terminal rate.
Investors with 6-12 months horizon can consider an allocation to low duration/ money market strategies, given that expected terminal rate is priced in. Investors with more than three-year investment horizon can consider allocation towards roll-down strategies and actively managed intermediate duration (one-to-four year) categories, given the reasonable starting levels of yield and potential to participate in downward yields momentum as global inflation pressures cool off.
The views expressed are the author’s own views and not necessarily those of UTI Asset Management Company Limited. The views are not investment advice and investors should obtain their own independent advice before taking a decision to invest in any asset class or instrument.
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