In India, apart from the manufacturing slowdown, there is an additional problem of the slowing consumer. Thus, consumption was being supported by rising leverage over the past few years as income and savings growth slowed.
Global manufacturing and trade are experiencing a sharp slowdown. The risk being contemplated is whether this starts percolating into services. In India, apart from the manufacturing slowdown, there is an additional problem of the slowing consumer. Thus, consumption was being supported by rising leverage over the past few years as income and savings growth slowed. This may now be turning, on the back of the local financing squeeze for some entities. There is possibly a behavioral component at work as well, as the consumer intentionally slows seeing lower fall back savings and an uncertain economic outlook. Additionally, ability of fiscal policy to backstop growth is constrained owing to around 0.7% GDP shortfalls in key revenue items like GST and personal income tax.
The New Escalations
Quite unexpectedly, US President Trump announced an intent to impose 10% tariffs on a further USD 300 billion of Chinese imports starting September 1. These rates can be further hiked in the future. China, on its part, has responded in two ways: First, it has allowed the yuan to depreciate below the psychological 7 mark. Second, it has instructed its agencies to stop procuring US agricultural imports. These events mark a substantial incremental deterioration in the trade environment, on the back of an already slowing global economy as described above.
What This Does and Does Not Mean
It is highly likely that this new escalation invites a more dovish response from monetary policy. In particular, the Fed Chair had described the recent cut as a mid-cycle, insurance cut. If the new threats persist, it is quite improbable that the Fed continues to view the current cycle as such. Indeed, the 3 month to 10 year inversion on the US yield curve is back to being at its highest in this cycle: a clear indication that the markets are back to leading the Fed. Other geographies are, similarly, likely to view this as a new ultimately deflationary event (although tariffs may have a first round inflationary impact), and according adjust monetary policy further.
We don’t think this means the start to a sustained period of Chinese currency ‘devaluation’. The last episode of devaluation in 2015 led to an accelerated depletion in their foreign exchange reserves which proved difficult to control for a while. Now growth is weaker and the current account surplus is even smaller. In such a scenario, we don’t think China will again risk destabilizing its external account flows.
Thus if this were to not trigger a ‘currency war’ as some are fearing, emerging market central banks may still retain space to ease policy. In our own context, the current account has shrunk reflecting falling growth versus potential, while foreign currency reserves are robust. Hence the central bank can very well overlook measured depreciation and continue to ease policy. Indeed, if global growth were to slow abruptly then one should expect the rupee to depreciate as dollar catches a ‘safe haven’ bid. This should not be a bar for local monetary easing.
Some Perspectives on the Indian Credit Experience
1. From a macro perspective, credit spreads are linked to the growth cycle and not to central bank easing. Indeed, spreads are often still rising when central banks start easing. This is because this easing is normally in response to a growth slowdown. So the macro logic for buying into lower rated credits, or ‘receiving’ spreads, will only fall in place when some stability can be seen in the growth cycle. As discussed above, that doesn’t appear to be the case so far.
2. From a ‘micro’ standpoint as well, the local environment for credit is far from stable yet. Episodic resolutions of particular names help to alleviate stress to investors and are therefore obviously welcome. However, they hold little information on the general environment. In particular, most financing that is flowing through is at an asset level, rather than at a balance sheet level. This is an important distinction and needs to be clearly recognized. Thus lenders are willing to take out particular assets that they like, but are reluctant in some cases to generally finance at the entity level. While this provides liquidity in the near term, the so-called ‘stressed’ entity may also then find future financing more difficult to come by, as the pool of such monetizable assets shrinks. Thus, for sustained resolution to happen, one must look for balance sheet level financing at a meaningful scale to start coming through.
3. Drawing from the above, the framework can be neatly branded as a “RRR” model (Recognition, Resolution, Recovery) as below.
a. Recognition: The unwillingness yet to lend at balance sheet level basically displays a lack of confidence in lenders that full recognition has happened. Indeed, given the size of lending to particular sub-sectors that preceded the ‘freeze’ from last year and the anecdotal evidence of onward liquidity and end demand falling off, it is possibly logical to intuitively expect more recognition down the road.
b. Resolution: Once recognition happens, one then moves on to the terms for injection of fresh debt or equity capital. This is the necessary condition of balance sheet level financing that was referred to above.
c. Recovery: Assets recognized and written off, and armed with adequate growth capital, the business of being a going concern now resumes.
It is to be noted that in the real world, the process doesn’t follow the neat sequence as described above. Neither do all entities follow the same cycle at the same time. Indeed, in the current context, it is possible to think of entities that are well into the second ‘R’ while, arguably, some others are still in the very nascent stages of the first ‘R’. However, this is a useful template to think about the more micro aspects of the current situation and will also help assess when a turnaround is potentially coming. Finally, it is to be noted that resolution in some entities helps build confidence with respect to many others which are though fundamentally robust, are nevertheless possibly getting caught today in the generalized risk aversion.
4. There are two conditions for investing into any asset class: 1> Valuation 2> Narrative. Each is necessary but not sufficient by its own. As an example, lower rated credit spreads were displaying classic late cycle froth over the past two years, possibly backed by next to zero default expectations. As opposed to that, spreads currently are at a cycle high but the narrative is weak as described above. If the product class is indeed to be viewed dynamically, then asset managers should be as quick to point out thinning spreads just as the wider ones are being brought to notice now. Irrespective, given the relatively weak backdrop today, credits possibly satisfy the necessary criterion of valuation but not the sufficient one of narrative.
5. Ultimately, any investment decision has to be backed by a robust asset allocation framework. Our best one is to talk of fixed income allocations under three buckets of liquidity, core, and alpha. The core bucket, that should represent the bulk of fixed income allocations for a conservative investor, should be low on both duration and credit risks.
Unfortunately, credit risk funds have been mis-termed ‘accrual’ and mis-allocated to the core bucket over the past few years. Whereas they belong in the alpha bucket, besides active / long duration products. Given this misallocation, and despite some rationalization over the past year, most investors are today anyway still under-allocated to AAA/low risk in their core buckets. Thus the context, irrespective of view, is still one of the urgent needs to repopulate the core bucket with the right products.
[Disclaimer: The author is Head – Fixed Income, IDFC AMC. The views and opinions expressed in this article are those of the author and do not necessarily reflect that of Business Television India (BTVI)]