Short-Term Volatility, Potential Opportunities in India
India’s macroeconomic picture today appears to be much improved from 2013, when real rates were low and inflation was prevalent. Our view was confirmed following our recent visit to India to meet with a wide range of local market participants including fund managers, bank treasurers, and various chief investment officers.

A crisis of confidence, however, triggered by the September 2018 default of a major non-bank financial institution (NBFI), spread rapidly to other market participants. That had the effect of withdrawing liquidity from the market, which immediately impacted credit growth and will affect consumption and real GDP down the road. This transpired during a period of higher current account deficits due to rising oil prices and a weak external environment.

India faced another challenge more recently when, on December 10, Reserve Bank of India (RBI) Governor Urjit Patel resigned due to what many believe was a political disagreement with the central government. The government was not a proponent of the prompt corrective action (PCA) championed by the RBI that limited the lending abilities of weak public-sector banks, and established a tight liquidity policy toward NBFIs.

We firmly believe an independent central bank is necessary for India’s macroeconomic stability, and hoped the dispute could be solved amicably. However, that was not the case, and Shaktikanta Das, an ex-finance ministry official, was appointed as Patel’s replacement. Das has a challenging task as the issues that led to Patel’s resignation have not been resolved. These India-specific headwinds, along with recent challenges facing emerging markets in general, have led to a repricing of local assets, from equity to sovereign bonds to the currency.

India’s Economy: On Firmer Footing Than in 2013

Notwithstanding these challenges, we believe economic conditions in 2018 are not the same as they were in 2013. The RBI has tightened monetary policy, and fiscal policy is largely contained despite the upcoming general election in May 2019. In addition, low food inflation is helping keep overall inflation in check. Whether structural changes will support this in the long term remains, however, an open question.

Real rates are high, as is the case in many other emerging markets, and help compensate investors for some of the risks, such as the need to finance India’s high current account deficit. With rates on 10-year sovereign local bonds at approximately 7.5%, down from their 8.20% peak in September 2018, the worst could well be behind India.

We believe current local positioning is dominated by traders at various international and local banks, making market swings more volatile. As a result, we believe it will not take large flows from either onshore or offshore real money managers to start a significant move lower in interest rates, as inflation remains under control and growth starts to trail off further by the second quarter of 2019.

In the view of many investors we met with during our trip, potential short-term volatility may well be managed by the RBI’s open market operation program to buy government securities and infuse liquidity into the system, and foreign exchange interventions with the Indian rupee. Despite potential short-term volatility, we view the medium term more favorably, especially from an interest rates perspective.

We currently own a mix of front-end exposures, mostly in the form of sovereign government bonds but also some Indian corporate bonds. We have begun adding duration risk over the last few weeks and are looking for further opportunities to roll out our exposure to the long end of the yield curve as we get more comfortable that our inflation and growth outlook are correct.