Reflecting back, the onset of 2023 was characterized by a somewhat bleak outlook, as forecasters anticipated ominous challenges on the horizon. The global landscape was marred by various issues, encompassing a war in Europe, elevated commodity prices, the cascading repercussions of decade-high interest rates and monetary stringency, persistent inflation, a decelerating Chinese economy, a Europe in decline, and concerns regarding a potential recession in the U.S.

However, we were all surprised with the resilience seen in global growth, primarily contributed by the US, with underpinnings in its strong labour markets. Further, the momentum of inflation cooled quicker than markets expected in the second half of the year and the six-months annualized core Personal Consumption Expenditure price index is already at target! Throughout the year, the Fed’s hawkish tone resulted in markets belatedly believing in the “higher for longer" maxim and pushing US-10-year yields beyond 5%.

Who moved the cheese?

But come December 2023, Jerome Powell decided to play market Santa Claus and in all but pivoted in his last policy, after which markets have quickly recalibrated and are now baking in six rate cuts over the next calendar year, rallying significantly.

There is enough reason to believe that the pendulum has swung again to the other side of exuberance and rate cuts will be more calibrated despite cracks in the US economy beginning to appear. The European Central Bank (ECB), however, was relatively hawkish and did not discuss rate cuts in its meeting despite many European countries toying with recession this year.

No further rate hikes are likely, however. China continues with its tepid growth and despite some policy interventions, the mainstay property market remains sluggish and continues to struggle with low demand offtake. Compounding issues for them is the slowing export growth due to slowing global growth. Recent geopolitical developments in the Middle East have also added to the complexity.

The India story is different

In India, the story was always different due to the almost Goldilocks situation of strong growth coupled with a downtrend in inflation. Most of the high frequency indicators of PMIs, credit growth, tax collections, e-way bills, passenger car sales, and capacity utilization—other than the external sector—continue to flash bright green, pointing to a healthy continuing underlying momentum. CPI inflation has continued its broad decline despite intermittent shocks from volatile vegetable prices and the decline seen in the sticky core inflation is particularly heartening.

With the recent inclusion of India in the JP Morgan Index it is estimated that we see inflows of approximately $30-50 billion, having a positive impact on the external account, forex reserves and the Indian currency, over and above the obvious positive impact on yields. Liquidity is expected to remain broadly balanced blunting the use of that tool for the RBI.

Thus, despite real policy rates remaining firmly in the positive territory, with no compelling reason to cut, the “higher for longer" maxim continues to hold, particularly since we have a very slim cushion given that the long-term repo rate in India is closer to 6% and the current repo rate is at 6.5%. This is very different from the US where the long-term Fed rate is closer to 2%, giving them significant headroom to cut when required. We believe we are likely to see a shallow rate cut cycle only in the second half of FY25.

Risks would broadly emanate from the external sector—due to geopolitics and any resultant energy price shocks. The year 2023 cemented the notion that the old-world order that we knew and that existed for many decades is under threat and a change to a multi-polar world with fluid alliances is underway. Suffice to say that volatility is the only certainty!

What should investors do?

Corporate bond spreads are finally showing signs of expanding. With Corporate India’s credit metrics in fine fettle and previously abundant liquidity, spreads were compressed for many years. However, all this is likely to change with balanced liquidity and the change to risk weights by banks for a few asset classes.

The year 2024 is again starting on an interesting note. With our expectations that central bankers have ended their rate-hiking cycle against the backdrop of declining inflation, the positive real returns that current rates point to, augur well for increased fixed income allocations in 2024. Demand supply situation from the sovereign curve is now more favourable compared to last year due to likely fiscal consolidation and bond indices inclusion. The expected neutral liquidity situation would limit RBI’s ability to do OMO sales. Thus, we would expect benchmark G-Sec to gradually move lower during the year and average in the range of 6.75-7% during 2024 and thus provide a window for potential capital gains.

Most likely in 2024 actively managed duration funds can do well within fixed income space. The entire yield curve between 1-3 year is available at 7.75% - 8.0%. Given our macro views, these rates are unlikely to inch up much higher. Investors should not expect any immediate gains from rate cuts since they are a while away and should instead look at an accrual play. More intrepid investors can look at the tactical opportunity being supplied due to the bond index inclusion and invest in Gsec funds or funds that invest predominantly in FAR securities. Time for dialling in active duration risk through short-term funds (Short Duration fund, corporate bond fund, and Banking and PSU Fund) is still apt.

Source: ABSLAMC Research

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