Amidst The Chaos : A Fixed Income And Macro Update

Introduction

The narrative on global reflation has been shifting as the year has progressed. In the first few months of 2021, with a fresh US stimulus program having seen the light of day, the narrative was one of a continuously improving growth trajectory as first the stimulus and then the reopening effects came into play. As more and more of the world re-opened demand would gradually start shifting from goods to services. Inflation would average higher for now but as some of these rotations took root, it would then start to trend lower towards Fed’s longer term goals. The average inflation targeting (AIT) regime as well as being reactive rather than proactive to inflation, would keep financial conditions very accommodative even as the global recovery kept strengthening. Yield curves where correspondingly steep, reflecting this gentle normalization and the general expectation that central banks will be able to manage the transition smoothly.

To clarify, there isn’t a sea-change to the above dynamic. That said there are important and undesirable incremental developments to contend with.  There has been another Covid wave that has postponed the demand shift towards services and has prolonged the supply bottlenecks that have plagued the global economy over the past few quarters. Combined with the after-effects of a very hefty fiscal stimulus in the US, this is leading to unprecedented shortages. These have become self-affirming in the short term with anxious stock-keepers and consumers advancing purchase decisions in many cases, thereby accentuating the shortages. The cost push pressures are now so intense that they are quite clearly impacting sentiment, surely a very undesirable state of affairs from a policy making standpoint; especially when, as in the case of the US, both fiscal and monetary policy have decidedly gone above and beyond in their response. Bond markets are now expressing this state of affairs by flattening the yield curve, thereby signaling an expectation that the Fed will have to normalize earlier even as they bring down their expectation of what the likely terminal rates will be in this cycle.

Ocean Liner Meet Speedboat

The Fed’s revised policy framework has been carefully thought out and has been the result of experience gleaned from the years running up to Covid. In that period, unemployment rates fell to levels previously considered below trend and yet there was no evidence of generalized wage inflation. In other words, the benefits of employment could percolate in a much more wide-spread fashion than previously thought possible without engendering inflationary pressures. Further, by sticking to a previous framework of inflation – unemployment trade-off and starting monetary policy normalization, the Fed may have actually delayed the attainment of full benefits of a robust labor market.

Thus the Fed reformatted their framework towards average inflation targeting, and being reactive to inflation. Furthermore, a guidepost during the Covid response to the Fed has been the labor market that existed in February 2020, which has described above was throwing up abundant employment but wasn’t leading to generalized wage pressures. Thus so long as the actual market was short of this level, the predominant effective variable for policy was unemployment rather than inflation. Given this understanding of longer term drivers of inflation, the Fed has been comfortable characterizing the shorter term spikes in inflation as transitory. However, lately the confidence with respect to this characterization has somewhat waned as is natural. This is as the actual realized prints have surprised both in magnitude as well as in persistence. There is also the related point about how long an episode can be called transitory especially if it start impacting behavior of economic agents.

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As can be seen from the chart above not only is the headline CPI at a multi-decadal high but even core inflation has spiked to uncomfortable levels. This is unlike the last episode of energy price spike that had happened in 2007-08 when, as can be seen from the chart, core CPI had remained relatively better behaved. True the so-called ‘bull-whip’ effect works in both directions and some of the price spikes may come off as sharply as they have risen (as stock keeper and consumer behavior starts running in the opposite direction). In fact already, some of the pressures in the energy market (natural gas, coal prices) seem to be abating. However, there are counter-balancing factors as well. The charts below show that even ‘lazier’ measures like trimmed mean CPI are moving up whereas contribution from outside of food and energy is also noticeable now. In particular analysts worry now about the larger contribution from housing as is also seen in the chart below (although the Fed’s preferred inflation gauge has a lower weight to this component).

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The dilemma here for the Fed, at least in the short term, is that it is still expanding its balance sheet and has policy rate at effective lower bound when a variety of inflation measures are the hottest they have been in decades. And while many in the market want the Fed to correct this, the problem is that both the framework as well as the effects of monetary policy changes on economic activity are slow moving things. In some sense then the Fed is captaining an ocean liner and by definition cannot have the agility of a speedboat. Even more, since the new framework is recently thought through and implemented, the level of inertia may perhaps be more than what may ordinarily have been the case. Nevertheless, this dynamic is clearly undesirable and has potential for continued volatility in global rate expectations till this divergence settles down.

India’s Macro Dynamics

The best of our own CPI seems to be behind us. While the recent excise cuts on petrol and diesel are welcome, they are being negated by a sizeable jump in food prices and the persistent upward pressures on core inflation. As can be seen in the chart below, core momentum has been progressively climbing.

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We expect CPI to steadily head towards 5 – 6% area from here, after having enjoyed the 4% handle readings for the past couple of months. Increasingly, the worry is of headline inflation converging towards core as more and more pass throughs get undertaken in a general environment of relatively stable demand. That said, from a real rate and inflation differential perspective versus developed markets (particularly US) we are in a good place. Also, as discussed here before, the differentiating factor really is the relatively nuanced fiscal response here which is allowing growth to come back largely in line with the productive capacity of the system. Thus while shortages and cost push factors are a global phenomenon and hence are applicable here as well, they aren’t being accentuated by an over-stimulated demand environment as one can possibly argue in case of the US.

A Strategy Update

As is evident from the above narrative, there is substantial volatility in the global environment for the time being. This will most likely eventually resolve itself as a combination of somewhat greater agility from central banks and some of the temporary factors in play resolving themselves. That, at any rate, is what many developed market yield curves seem to be signaling towards. That said, however, there are always risks in this period where expectations are in disequilibrium with reality. These aren’t periods of ‘steady state’ and hence ask for greater watchfulness from portfolio managers as well. Our own yield curve remains steep and swaps continue to price in a robust normalization cycle ahead. Thus in one way we are quite geared for the monetary policy normalization that is already underway and its likely path ahead. That said, it is not necessary that the journey to getting there will be devoid of all volatility. The swap curve is already reflecting these adjustment pains. The bond curve has been much steadier so far given a relatively well behaved supply calendar. Indeed, our preferred 5 year sector has been very rangebound thus far offering not just the carry benefits but also very little mark to market volatility.

Our continues reassessments of portfolio strategy is a function of both near term and more medium term factors. The medium term drivers for our thinking are well documented before (https://idfcmf.com/article/6175, https://idfcmf.com/article/5730 ). These inform the basis for our fundamental portfolio construction and, in particular, the focus on bar-belling as the most effective way to navigate interest rate volatility. The extent of bar-belling, especially in more actively run bond and gilt funds, is informed by more shorter term considerations. For most times, we have preferred running close to fully invested books in light of the substantial carry loss associated with holding cash. From time to time, however, we have bar-belled (via raising cash or near cash) as we thought shorter term factors required more active navigation. In our assessment the current phase, in light of some of the dynamics described above, may well require some active management again. Reflecting this, we have raised cash / near cash approximately in the range of 30 – 40% of portfolio in our actively managed bond and gilt funds as at 12th November 2021.

Given the bond-demand supply dynamics, we are always suspicious of arguing for mark to market gains from bonds (or yields falling sustainably). Thus the quantification of costs from running cash is always in terms of carry loss on assets. For the near term this is a trade-off we think should be acceptable if it leads to a lesser volatile way of eventually earning said carry. Finally, what has been presented here reflects our current thinking. As always this can change at any point in time.

Disclaimer:

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The Disclosures of opinions/in house views/strategy incorporated herein is provided solely to enhance the transparency about the investment strategy / theme of the Scheme and should not be treated as endorsement of the views / opinions or as an investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document has been prepared on the basis of information, which is already available in publicly accessible media or developed through analysis of IDFC Mutual Fund. The information/ views / opinions provided is for informative purpose only and may have ceased to be current by the time it may reach the recipient, which should be taken into account before interpreting this document. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision and the security may or may not continue to form part of the scheme’s portfolio in future.  Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. The decision of the Investment Manager may not always be profitable; as such decisions are based on the prevailing market conditions and the understanding of the Investment Manager. Actual market movements may vary from the anticipated trends. This information is subject to change without any prior notice. The Company reserves the right to make modifications and alterations to this statement as may be required from time to time. Neither IDFC Mutual Fund / IDFC AMC Trustee Co. Ltd./ IDFC Asset Management Co. Ltd nor IDFC, its Directors or representatives shall be liable for any damages whether direct or indirect, incidental, punitive special or consequential including lost revenue or lost profits that may arise from or in connection with the use of the information.

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