Fixed income in India increasingly looks to be in a sweet spot, not just domestically, but from the global investors’ standpoint as well. The strategy for bond investing in 2012 will be determined by the growth/inflation outlook for our country. As per our internal framework, we believe that the following scenario will play out in our economy:

•    India will grow at below seven per cent for FY12 and FY13. Only towards the end of FY14, will we get back to the ‘normal’ or ‘potential’ growth level, i.e. 8.5 per cent.
•    The inflation situation in India will subside. In March 2012, inflation will be closer to 6.5 per cent, and FY 13 inflation will be in the range of 5.5-6.5 per cent.

In order to understand the expected slowdown in growth, let’s first revisit the factors that drove our economic growth after the 2008 crisis. A massive fiscal and monetary stimulus was unleashed in our economy, since the world was facing a financial crisis. Government spending shot up, taking our fiscal deficit from 2.5 per cent to almost 10 per cent. Most of the incremental spending by the government went into the wallet of the common man, whose propensity to consume is very high. The Sixth Pay Commission, Farm Loan Waiver Scheme, NREGA and various such schemes fueled a consumption boom. Life looked easy. Pundits concluded that India had decoupled from the rest of the world.

Alongside, there came a huge asset price boom.  Everyone in this country had a story to tell about how his/her friends and relatives had become millionaires by buying some parcels of land. An Indian already ‘earning more’ received a booster shot of wealth, and was suddenly richer, and the property price rise wasn’t the only reason for it.

A typical Indian owns two asset classes – gold and real estate. On one hand, government spending and loose monetary policies spelt magic for real estate prices. On the other, gold prices rallied for non-domestic reasons (largely driven by the chase for an alternative currency, as confidence in global currencies sank). Gold, which is typically bought as insurance by the average Indian, began to look like an investible surplus. Gold loan companies flourished, as people began to leverage their gold holdings. Thus, both gold and the real estate price boom added fuel to the consumption boom.

However, times are different now. The wealth and income effect that drove consumption growth are fading. Property prices have stopped rising in most parts of the country for the past six months. Gold prices too, have come off (optically though, they still look high due to the currency depreciation). The government doesn’t have money to spend, as it failed to consolidate its finances in the ‘good times’. The world economy is struggling to grow. Growth in 60 per cent of the world (mostly in the developed nations), is likely to either stall or decline into a recession. Interest rates are very high and taxing. All these reasons explain my first view, i.e. there is an economic growth slowdown ahead for us, and our models tell me that the growth next year will be as low as 6.5 per cent.[PAGE BREAK]

Now, let's understand what happened with regard to inflation. For the past two years, India has experienced a rather acute state of inflation, which sustained itself at above nine per cent for most of this period. There are three levers of inflation – domestic demand, global commodity prices and Indian supply. All three worked in favour of higher prices. We have already discussed the domestic demand situation, which was essentially driven by the consumption boom. While we were splurging, the investment climate was deteriorating. Policy inertia, high interest rates and global economic uncertainty made investors wary of investing more capital, and unfortunately, the consumption boom didn’t coincide with higher investments.

The situation is taking a gradual turn. Lower growth, both in India and the rest of the world, would take the pressure away from inflation. The run rate of inflation has already fallen significantly. A buoyant rural economy, which drove both consumption and inflation higher, is likely to face strong headwinds, as government redistribution schemes slow down (due to bad fiscal conditions) and the wealth effect fades (due to falling or stalling property prices). That is why we believe that inflation will cool off rapidly in the coming months. More importantly, it is likely to range around six per cent for many quarters ahead, with a downside bias.

Once we understand the growth-inflation dynamics, it is easy to predict how interest rates will behave over the next few months. The following are my predictions in this regard:
•    The RBI will cut the CRR by 50 bps within this financial year and another 100 bps in FY13 (most of it in the first half).
•    The RBI will cut interest rates by more than 100 bps over the next nine to 12 months.
•    The entire corporate bond curve will shift down by 75/100 bps over the next nine to 12 months. The curve will steepen, meaning that the short end rates will move down more than the longer end rates.
•    Good quality corporate bond spreads will continue to shrink. Lower credits’ spreads may widen.

Let me conclude with some investment advice for readers. My investors generally take debt exposure through bank FDs. I invite them to invest in debt mutual funds, as there are some very good opportunities that are far more attractive than bank FDs. Individuals should invest either in long-term FMPs or medium- to long-term income funds. They can specifically look at the Birla Dynamic Bond Fund, Birla Income Plus and the Birla GSec Long Term Plan to benefit from lower rates in the future.

KEY POINTS

•    While it is natural to get affected by the short-term performance of the stock market, don’t allow it to influence your long-term investment strategy.
•    Negative returns do not necessarily mean poor performance. Even the best of fund managers are likely to deliver negative returns during periods when the markets go down significantly.
•    After ascertaining the right level of exposure to every segment of the market, consider getting rid of some of the schemes to get the right balance, focussing on those funds in that have been performing consistently and have good quality investments.
•    No matter how young you are, the sooner you begin investing, the better. Since investing is a continuous process, you can begin even if you don't have a lump sum amount to start with.

- MANEESH DANGI, Co-Chief Investment Officer - Birla Sun Life Asset Management