Inflation to settle around 6% mark with downward bias

Badrish Kulhalli

1.With interest rates set to head lower, is this a good time to be investing in fixed income mutual fund schemes?

Interest rates have been softening since the start of the current financial year. However, a number of factors have turned positive for the fixed income market over the recent months. India's macro economic parameters have improved and the outlook continues to be positive. Inflation has eased, and even after adjusting for base effects, we contend that the CPI inflation already is moving around 6%, which is RBI's target for 2016.

The fall in energy and commodity prices has improved the outlook for the country's trade deficit as well. The total Current Account Deficit is, hence, lower and easily financed through the flows on the Capital Account. As a result, currency vulnerability has reduced dramatically. From being one of the 'Fragile Five' last year, the Indian Rupee has been among the best EM currency this year.Lower oil prices is also reducing the pressure on the Government's finances and this affords the Government some room to reform the energy sector.Secondly, apart from the fall in commodity pries, the Government is committed to continue the trend of fiscal consolidation. The Government is actively working to improve growth and employment in the domestic economy and improve its revenues as well. If the current efforts of the Government are fruitful, then the fiscal deficit will contract to 3.1% of GDP over next two years. It will put the Government's finances on a strong footing.The improvement in the economy's fundamentals has attracted FII inflows into the domestic debt market. India is an attractive investment destination with improving fundamentals, stable currency and good growth prospects. For the current calendar year, debt FII flows have out-stripped equity FII flows by a wide margin. These FII flows are expected to continue in the coming few quarters as well.We expect that the current trend of lower interest rates to continue. 2.Do you expect the RBI to cut interest rates at its February policy review meeting?We believe that the February policy meeting will be a close call. Though all factors for the start of the rate cut cycle are in place, we need to look at RBI's conditions for rate cuts a bit more closely. In the last policy statement, the RBI had mentioned that the stance of the monetary policy will change depending on the continuation of the disinflation momentum, a change in inflation expectations and further consolidation of the government's fiscal position. At the time of the February policy, we will have only one inflation reading post the base-effect led fall. Moreover, the fiscal policy stance will be presented by the government within a month of the policy. So the RBI may as well wait for the Budget that will be presented at the end of February, assess the above factors and then decide on the interest rates. We expect that in such a scenario, the rate cuts may be pushed to March or April.3.What is your outlook on GDP growth for this year and the first half of next year?GDP growth for the coming quarters is likely to see only a modest pick up from the last quarter levels. We are seeing a minor revival in the manufacturing sector due to cyclical factors. IIP and PMI numbers attest to the revival. Services sector is also seeing an uptick. However, manufacturing will face some headwinds from the slowdown in exports due to combination of weaker growth in large economies as well as a stronger currency. Agriculture growth in the current quarter may dip due to the effects of the deficient monsoon. However, the subsequent quarter may see better growth on waning of these temporary factors. However, we expect stronger growth next year as we will see the effects of the new Government's policy decisions as well as the removal of hurdles that have stalled a large number of projects.4.Current account deficit for September has widened. Do you see it as a cause for concern?The Current Account Deficit (CAD) for the September quarter has widened primarily due to the pickup in gold imports. The effect of the fall in crude oil prices have not yet been fully priced in. We expect that the lower oil prices will help contract the deficit in the coming quarter. So even with the higher gold imports, we do not expect the CAD to widen significantly. If we see GDP growth picking up in the domestic economy over the coming quarters, we can expect some pick up in imports of capital goods and some more pressure on the trade deficit and hence CAD. However, from a currency stability point of view, it is important to note that an investment and growth led widening of the CAD is also likely to attract capital flows that can finance the CAD. So the currency may not see much pressure due to the widening CAD.5.What is your outlook on the rupee and inflation?The current trend of lower inflation is a combination of actual disinflation forces triggered by lower commodity prices and a base effect due to the food price spike at this time last year. Post the base effect adjustment, we expect that the inflation should settle around the 6% mark with a downward bias. Major economies from Japan, China, Australia, Euro area are facing a slowdown in growth which is pressuring commodity prices lower. We expect that 2015 will continue to see lower commodity prices and low inflation pressures. Secondly, any investment led growth pickup in India will help in expanding the output potential for the economy and keep inflation pressures in check. We expect that we will see an extended period of low to modest inflation in the coming years.The rupee is likely to continue to depreciate against the US Dollar, as dictated by the differences in underlying inflation and interest rates. The pace of the depreciation, will, however, be dictated by developments in other EM currencies as well as the strength of capital flows into the country. The increase in the RBI's foreign currency reserves gives it the ability to smooth out any sharp volatility that may be triggered by external events. So we do not expect any undue volatility in the currency.