2020 was a year full of unexpected events leaving one with lots of learnings over the year, the one important take away being – predictions can go horribly wrong and one should always be flexible to adapt to the ever-changing situation. Accepting the situation, planning and timely execution has proved to be one of the most effective ways in saving economies and the market.
We are heading into 2021 with the global interest rates at or near an all-time low and liquidity being injected at a massive scale by major central banks. Top four central banks like the Federal Reserve System (FED), European Central Bank (ECB), Bank of Japan (BOJ) and Bank of England have injected ~$ 8tn in 2020 alone increasing their balance sheet size to $ 27.9tn (41.5% YoY change). Indian experience was also along similar lines with RBI injecting ~INR 10 tn into the system amounting to about 4.7% of GDP and cutting interest rate by 115bps during the year.
While there is no doubt that the steps taken by the central bankers across the globe have helped stabilize financial markets and aided to the economic recovery from the extraordinarily difficult challenge posed by covid-19 induced disruption, a still greater challenge remains in how soon the excessively loose monetary policy stance can be normalized. The last time a similarly disruptive situation was observed was over a decade ago in 2008 during the global financial crisis. Global central banks started a massive quantitative easing program then. Fed had barely planned to begin a reversal process a few years later in 2013 that the markets went into a tailspin again, the now famous “taper tantrum” episode. History suggests that central bankers have found it difficult to reverse the QE once started. The Bank of Japan has been doing it for nearly 20 years; Fed/ECB for nearly 12 years and they all are finding it difficult to return to normal. Increasingly there is a talk of Japanification of US monetary policy.
With this backdrop, turning to India, unlike western world where inflationary conditions are fairly benign, the situation in India gets a little complicated with inflation surging to a high of 7.61% in November’20, the highest since the new series started. Though inflation eased to 6.93% in Dec’20 (and is further expected to ease to closer to 5% in January’21), since the outbreak of the pandemic, inflation has largely remained higher than RBI’s target range of 4% with a variance range of 2%. India CPI basket has ~45% proportion to food products which is highly volatile based on historical trends. The argument often offered for the current high inflation is supply chain disruption during the lockdown periods. However, taking a closer look, the core inflation (excluding food and fuel) has also gone up from ~3.5-4.0% the previous year to ~5.5-5.8% mainly led by an increase in healthcare, education and transportation components. In 2021, the outlook for inflation remains challenging with most commodities prices moving higher. Many auto and consumer durable manufacturers have recently announced a price hike at the start of 2021. Likewise many steel and iron ore miners have also hiked prices off-late. Fiscal deficit for FY22 is also likely to be on the higher side to continue supporting the nascent economic recovery.
After peaking at just below 1 lac new infections per day and cumulative active cases of nearly 1 million in September, the Covid-19 curve flattened significantly in Q3FY21 and by end-December daily infection cases fell below 20k per day and cumulative active cases fell below 3 lacs. This improvement was particularly encouraging coming after peak festival season, elections in many states and the onset of winter season. Following the gradual unlocking of the economy during this period, GDP growth has finally shown signs of a strong recovery after a nearly 24% contraction in Q1FY21 followed by a less painful 7.5% contraction in Q2FY21. The high frequency data such as google mobility levels, car and two wheelers sales, property registrations and electricity consumptions suggest further improvement in economic activity in just concluded quarter ending in December.
Assuming a continued economic recovery and smooth vaccination roll-out, the MPC will need to evaluate the timing of normalizing monetary policy soon in a non-disruptive manner, an objective that has so far deluded other global central banks. Global economic recovery remains subdued and major central banks are likely to persist with excessively accommodative monetary policy in the foreseeable future. That will lend extra elbow room to RBI to continue with its current accommodative stance which is very much required to lend a helping hand to India’s economic rebound that is still at a nascent stage. Thus, MPC may not be in a hurry to hike interest rates in 2021. It is likely to tolerate higher inflation than it has in the recent past because after a tough 2020, the focus rightly will be on growth.
Thus, the theme for 2021 is going to be vaccine roll out, monetary policy reversal and growth story. Vaccines have been approved, and are expected to be available soon. This would hopefully solve a major part of the problem in H1 and focus would return on growth and monetary policy. Growth will continue to take centre stage and we should see strong support from the government through fiscal initiatives. Led by a visible recovery, interest rates may nudge higher but continued intervention by RBI through OMO/Operation twist may arrest any meaningful spike in rates. Lastly monsoon as always will play a decisive role in that situation and we can expect to get an early forecast on monsoon sometime in May’2021
However, even given the possibility that interest rates may rise somewhat, investors with a long term horizon may want to stay put in long term funds, bond funds as long they are willing to accept some volatility and are able to remain invested through a complete interest cycle. Investors should stick to goal-based investing. The choice of investing in debt should be based on risk profile and they should consult a suitable advisor as appropriate. Those with a short term horizon or worrying about volatility may invest in the low duration category.
(The author is the Chief Investment Officer – Fixed Income at Mirae Asset Investment Managers (India) Pvt Ltd)