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Fixed Income Outlook – April 2018

Market Outlook:

Volatility has struck debt and equity markets in equal measure in 2018. Valuations continue to remain an area of concern with respect to equity markets and volatility will continue to persist until earnings match valuations. This is a global phenomenon and is not restricted to domestic equity markets. Meanwhile, investor appetite for debt has reduced.

Our core strategy team has been working on attractive investment options within the fixed income space. Our strategies are expected to outperform traditional investments like fixed deposits (one-year) by 1% to 1.5%. Hedging your portfolio through proper asset allocation will help mitigate risk. To explore your investment options please get in touch with your relationship manager.

Global Sentiment:
Positive growth indicators and tame inflation are facilitating the Fed’s policy to hike interest rates. Globally, advanced economies are expected to follow the same cue. Interest rate hikes across the board could induce volatility in emerging markets like ours. More importantly, threats of a trade war, rising crude oil prices, geopolitical tensions, and protectionist sentiments could further pose threats to stability. Currencies are expected to weaken, as countries compete for exports and try to manage deficits.
Monetary Policy:
 The RBI’s neutral policy implies that a data-driven approach will be followed when it comes to managing the economy. Any adjustments will be made in a calibrated and gradual manner. The focus is on resolving stressed assets, improving transmission of policy rates, keeping inflation within the target range, and fostering an environment for higher economic growth.
Domestic Markets:

Bond yields have remained at elevated levels for a variety of reasons. The government breaching its fiscal deficit led the market to believe that there would be an oversupply of government bonds. Markets anticipated that the government would borrow more heavily in the current year. However, its announcement to restructure the borrowing program by following a more staggered approach using instruments of varying maturities has pleasantly surprised investors.

The recent scheme recategorization has created a more transparent and investor friendly system to understanding the classification of mutual funds.

Strategy:
Risk management always plays a central role in any investment strategy, especially when it comes to debt. A well-constructed portfolio should be able to weather uncertainties and deliver returns. To discuss hedging strategies through asset allocation, do feel free to reach out to our team.

Keep Your Chin Up

When markets correct sharply, where are you looking?  This question assumes special significance as the indices are down 10%+ from this year’s highs. And the lows don’t seem imminently near.

Effectively, we are now in a market where everybody has overplayed their hand. And, when you have overplayed your hand, the day will come when you simply can’t deal. There will be no money left to buy equities. That’s a simple rule of market trade.

We are yet to reach that point in this correction. But, it is almost certain that that point will be hit and even breached. When a breach happens, the pain will be unbearable. Selling will become overdone. The consequences of such breaches will be upon us for an extended period of time. While we warn of such impending pain, it is important to understand that there is a very big opportunity that’s before us.

It is coming at us. Slowly, it will build up and grow. We must learn how to play an opportunity as it grows right in front of our eyes. We must also play it carefully so we are in a position to deal with every opportunity when it presents itself. We should not become helpless spectators on that day when the markets are most irrational. We must keep our hand ready, prepared and willing to deal.

One fine day is waiting to come at us.

 

“Investment defense requires thoughtful diversification, limits on the overall riskiness borne, and a general tilt toward safety.”– Howard Marks

Volatility Returns

Politics makes a huge comeback in the stock markets, exactly when the markets are not ready for it. Unlike other market disruptions which pan out as standalone events, politics sets off a trend resulting in a series of events. Throw in a few economic events from time to time between the political event sequence and you have abundant volatility.

 


Fear gets freely manufactured and manifests itself in a secular way. Extreme fear rarely spares company valuations. At best, it affects a few companies less or it hits them late. Early volatility tends to hit companies which don’t have strong institutional backers, have higher free float, and have a broad based ownership. It later spreads to all companies when buyers aggressively withdraw and sellers start to queue up.

 


We still haven’t seen volatility spread and it has remained restricted to pockets. Secular volatility in the markets can make a very different impact altogether. For the moment, it doesn’t seem to be on the anvil.

 

“The degree of risk present in a market derives from the behavior of the participants, not from securities, strategies, and institutions.”– Howard Marks

Preparation Hour

The Indian markets started 2018 with an exaggerated sense of optimism. Clearly, headline numbers were lagging the markets. As the market moves towards the end of a financial year, that exaggeration is swiftly disappearing and getting replaced by fear.

We could see an overreaction on the other side too. And, investors with little or no exposure to previous cycles are going to be the most reactive to these trends. The challenge before us is not how we manage our investments but how we manage ourselves.
When investments do very well, we stop managing ourselves. We cease to follow the path of good sense and tend to get carried away.  Investments cannot always take care of themselves. They need our active management when their valuations go out of whack. To achieve that, we need to manage ourselves and stick to the path of reason.

The fact that the market was way off the path of reason is now coming home to hurt. While the excess valuations are swiftly correcting now, we don’t know where it can lead to. Stocks tend to become cheaper than we expect them to. We need to manage ourselves well to ensure we don’t let go of that opportunity to invest in equities.

From the need to sell equities aggressively early this year, we could swing to the other extreme where we may need to be buying aggressively. Clearly, we are in preparation hour.

“You can’t predict. You can Prepare.”– Howard Marks

Play Safe Now

A not so innocuous news report by a global brokerage set us thinking about where we are headed as a market. ” $1.2 billion waiting to get into midcaps says CLSA”.

The logic behind this premise interested us even more than the actual premise. The premise was that mutual fund schemes needed to change their portfolios to comply with certain new regulatory norms. To our minds, this looks every bit like a mindless exercise driven more by compliance needs. The logic of selling what you own with conviction and buying what you need to own by category is surely a blind spot. Impact costs are clearly going to hurt investor interest. They come at a time when fund NAVs carry a lot of price massaging. Clearly, the timing of reform in mutual funds is nothing short of awful. And, the impact is going to badly hurt investors.

Investors must steer clear of midcaps for a while. Let the pain settle down. The coming months are likely to be driven by global factors and volatility. Focusing on micro changes in our markets simply won’t help. This is a time when investors who fail to play safe are setting themselves to be sorry later.

 

 

“The biggest investing errors come not from factors that are informational or analytical, but from those that are psychological. Investor”– Howard Marks

Time to move forward

The FIIs have been persistent sellers of Indian equities. DIIs have bought steadily and supported the market. This explains the index not losing much despite heavy selling by FIIs. The regular domestic inflows are helping DIIs hold the market at higher levels.

In specific areas, like midcaps, we see funds continuously supporting stock prices of companies they are invested in. This is reminiscent of what happened in infra funds through 2008-2010. Domestic Investors kept pouring money into infra funds and were busy averaging down. Fund managers, in turn, supported stock prices. Eventually, the earnings started to wear away causing permanent loss of capital. Investors redeemed with a big loss.

Investing blindly on the basis of past performance is going to cause immense pain for investors. When markets shift towards newer themes and macro trends, investors need to quickly realign. This doesn’t seem to be happening. And, that is the biggest risk to the equity cult in India.

 

 

“Risk control is the best route to loss avoidance. Risk avoidance, on the other hand, is likely to lead to return avoidance as well.”– Howard Marks

Trend Reversal

The recent weeks are seeing the trend turn in several areas. Investment flows are looking very different with the persistent selling of FIIs in Indian equity.

News flows are also not looking great in February. For instance, first we had the budget levied long term capital gains tax on equities. Then, SEBI banned overseas stock exchanges like the SGX from using Indian indices to create products. Now, the PNB scam and the risk of its contagion effect on PSBs. Finally, the rising prospect of early elections in end 2018.

But these are more in the nature of reasons to explain market direction. The real reasons seems to be far more serious and structural. The uncertainty of global commodity prices, risks to fiscal discipline being maintained, upward pressure on inflation, possibility of rising interest rates, and the alarming prospect of a return to coalition governance are clearly worrying global investors. The higher volatility in global markets is definitely not helping matters either.

After enjoying decent macro tailwinds for a very extended period of time, we seem to be heading into a phase of macro headwinds. Such a phase inevitably leads to a lot of top down basket selling of the indices by global investors. Events of the past few weeks seem to reaffirm the onset of this selling trend.

Will this trend grow into a flood or will it reverse quickly? We will know in the coming weeks.

 

 

“The safest and most potentially profitable thing is to buy something when no one likes it.”– Howard Marks

Trouble comes in threes

”Trouble comes in threes” goes the proverb.

So, when the budget threw capital gains tax at our stock markets, we kind of knew that it was not going to be the end of bad news. The U.S markets quickly went into a steep fall on two sessions, sending global markets into turmoil. The Indian markets kept stabilizing after each day of turmoil in the US markets. But these are more in the nature of a habitual “Buy the Dip” strategy adopted by domestic mutual funds and retail investors.

Two trouble spots for our markets are now amply clear. The curious question is where can the third trouble spot emanate from for our markets? Inflows into mutual funds seem to be stable and show no imminent sign of slowing. There are no imminent worries for investors. People seem to show ample confidence by buying into corrections. FII selling is a spot of bother. But, their selling seems to be getting absorbed comfortably. So where can the third spot of trouble emerge from?

One potential trouble spot can be the global bond markets. Bonds can put equity in a bind. And the trouble will possibly start with the US markets and rattle global debt markets. This will set equity markets up for an earnings reset. An earnings reset can potentially lead to a valuation reset. We need to have a more risk averse approach to investing. Expect more trouble.

 

“Recognizing risk often starts with understanding when investors are paying it too little heed.”– Howard Marks

Redemption Time

Selling is never easy. Much as investors love profits and die to make more of it, when it comes to taking it, they hate to press the exit button. The overwhelming emotion when the finger heads towards the exit button is fear.

“What if you miss out on more profits? Would it not be a tragedy to exit early?” Doubt stops the right actions. Most investors who are overwhelmed by fear never sell. On the contrary, they buy heavily at market tops. And, when the markets correct sharply, they panic. Sounds familiar, right?

So what is it that can counter the new-high headlines screaming at you from the pink papers? Or the party buzz that is all around you. Or, the fear of missing out. There is only one thing that saves the day if you really want to save it for yourself. Contentment.

If you know things are really much better than you expected and everybody else thinks there is more to come, you need to just listen to yourself. Cut the noise out and take a few simple clear sell decisions. Then, execute them and walk away from the crowd. Don’t bother what happens for a few weeks. Or, even for months if you need to.

But remember that you were in the minority that took profits. The majority in the Indian stock market merely watch profits get created and destroyed. You are in the minority that redeemed.

 

“Most people are driven by greed, fear, envy, and other emotions that render objectivity impossible and open the door for significant mistakes.”– Howard Marks

 

A New Year Greeting

As we bid adieu to a wonderful investing year and welcome a new one, it’s time to pause and ruminate a bit. It is that time when we set our expectations. We actually need to assess how expectations played out in 2017.

Investment performance significantly outplayed our expectations in 2017. We did far better in the stock markets than in the real economy. That’s not unusual. Often, stock markets run ahead of the real economy. Now, economic performance needs to catch up with the stock markets. Can the markets keep running ahead of economic performance for two years in a row? While we can’t rule it out, it would mean that the economy will come under very severe pressure from the stock market. And, at some point in time, the stock market will lose patience and confidence.

The key factor to watch out for now is economic performance. This would be a shift from the company-focused approach that worked exceptionally well in 2017. The best thing to happen for investing will be the return of economic growth.
While the markets seemed unaffected by bad news in 2017, taking everything in its stride only to head higher, 2018 will certainly test its resilience and patience.

 

“The road to long-term investment success runs through risk control more than through aggressiveness.”– Howard Marks