Is recession coming soon?

India’s GDP

If we look into the downfall of India’s GDP in 2008 and 2012 there was a huge downfall. And currently, it is also showing downtrend which can show us that in the near future there are chances of GDP going further down and some other indicators support the fall in this GDP.

There are some factors which are making us believe that there is a huge chance of recession in the near future.

Nifty Returns

As we can see in the table below, there has been a reduction in the return given by the markets in the years when the GDP Growth rate is low. This clearly suggests the positive relation between market returns and GDP Growth rate

YIELD CURVE

If the difference between the interest short run and long-run interest rates starts to reduce, it means that the economic position is weakening. The yield curve is steeper for India and the growth rate of India is diminishing.


If we see the graph above, though the difference has increased it is presumed to converge in the near future and can lead to a slowdown in India’s economy.

P/E and EPS

The red line indicates the P/E, P/E ratio has crossed the EPS line, this can be indicative that the index is overvalued and can fall in the near future. As in a period of 6 months, the market has been performing good but P/E didn’t cross EPS. So if the correction comes in the market there are chances of the market falling.

These are some of the indicators which may predict a slowdown in the recent future if the indicators tend to state the information in a similar way and do not diverges.

Unemployment Rate

According to experienced economists, the unemployment rate has been at 45 years high. In 2018, the unemployment rate rose to 6.1 %.

If we see, in the year 2008 the unemployment rate was at a maximum of 4.116%. Now it is way higher than the last few years. So this is one of the indicators stating the downtrend in India’s GDP in current and upcoming years.

Chances of war with Pakistan?

Since 1947 partition, India and Pakistan have come across there have been many reasons for conflict between India and Pakistan. There are huge chances of Indo-Pak war, because of ceasefire violation. On 14th Feb 2019, terror strike which lead to the death of 40 Central Reserve Police Force personnel were killed on Feb 14, 2019. After 12 days of Pulwana attack, India strike on Jaish-e-Mohammed on Pakistan soil which lead to a huge tension between India and Pakistan. This tension if continues can hamper the growth rate of India and somewhat indirectly contributing to the recession.

Oil Shock

Rebounding oil prices have pushed up oil import costs and will widen India’s currency account deficit. This will, in turn, weigh on the rupee, which is expected to depreciate further, economists say. India could overtake China as the world’s largest oil demand growth centre by 2024, according to a Wood Mackenzie report. Oil prices have shot up this year, and are set to go up further when sanctions on Iran kick in. The increase in oil prices and India being one of the largest importers of crude oil, can lead to an increase in the current account deficit and hence, contributing to the downfall in India’s GDP.

Author
Apoorva Goenka
Team Leader- Equity Research & Valuation
(MSc Finance, NMIMS Mumbai. Batch 2018-20)

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Japanification of the Eurozone Bond Market: Navigating Through Negative Yields

Is the Eurozone heading towards a fate similar to Japan with sticky disinflation, negative interest rate, asset purchase extravaganzas? Can we still generate positive returns from the European sovereign credit markets with relatively low risk, in such a negative yield environment wherein almost 14.63% of bonds have a negative Yield to Maturity (YTM) (Out of which 73% of negative YTM bonds have been issued by Western European countries such as Germany, France & by Japan in Asia)?

Source: Barclays, PIMCO
Source: Barclays, PIMCO

Active management of bond portfolios can help us effectively navigate through this negative yield environment and generate better than expected returns on our investments. In order to select the optimal active bond management strategy for the European sovereign credit market and to learn how we as investors can leverage the same, we need to understand the fundamentals of the economic prospects of the nations in the Eurozone and how they might be in the same boat as the BOJ.

Eerie Similarities

The “Disinflation” Era:

Annualized Inflation Rates (Japan: 0.3%; Europe: 1.6%; Target: 2%): Bloomberg

Both the European Central Bank (ECB) and the Bank of Japan (BOJ) are struggling through sticky disinflation with the CPI (Consumer Price Index) undershooting their 2% target for most of the past decade. In order to prop up inflation to healthier targeted levels of 2%, the BOJ & ECB both have implemented numerous & sometimes even outrageous policies which sound absurd at first such as negative interest rates, asset purchases (equity & debt), loans at ultra-favorable terms & last but not the least the “Yield Curve Control” by the Bank of Japan (BOJ).

Let’s dig a little deeper to understand how these policies affect the European credit markets and how can use them to structure our trade.

“I want to borrow money & want you to pay me for the same”

If I came to you with the above proposal, you would probably think I’m crazy to even think about it. For years, economists and central bankers have had to deal with the problem of Zero Lower Bound (ZLB) on interest rates, which in turn restricts the extent to which central banks can stimulate the economy by managing monetary policy by navigating interest rates.

To counter this problem, Haruhiko Kuroda (Central Bank Governor, BOJ) & Mario Draghi (President, ECB) implemented this novel idea of “negative interest rates”. Negative interest rate here refers to the deposit rate i.e. the return banks get on their excess reserves (IOER) parked with the central bank. The whole motive behind this move was to disincentive banks from holding excess reserves and extend more credit to the economy. They expected this policy to amplify expenditure, wages and hopefully inflation. However, due to ageing demographics, low business confidence, lower credit demand growth and shrinking bank margins, inflation expectations have been consistently anchored below targets.

“Sir, what would you like to buy today? Japan, please”

Since negative interest rates were struggling in the background, the central banks started buying financial assets such as equities & bonds from the secondary market in order to inject liquidity. The expectation was that if the central bank buys bonds from investors, investors will expend the cash received and there will be scope for higher inflation through higher spending as they likely won’t invest the proceeds in negative yielding instruments available within the country.

Balance Sheet as a % of GDP: Bloomberg

With these expectations, the BOJ (yellow) ballooned its balance sheet away to as much as 100% of GDP! ECB’s assets as a % of GDP (white) have also jumped from 20% to 40% in the last decade. So while the ECB and BOJ were filling the glass (economy) with their rich milkshake (money), the Fed (green) decided to switch off the tap and replace it with a straw. In other words, most of the liquidity or money injected through the above policy measures found itself gravitating towards the US which officially stopped it’s balance sheet expansion and in fact started to “normalize it’s balance sheet”, effectively withdrawing liquidity. This lead to lower spending in the European economy and thus a muted inflation print. The phenomenon is also known as the “Dollar Milkshake Theory”, but that’s a topic for some other post.

“Are you a control freak? BOJ is.”

So in order to have control over the yield curve (which in turn heavily affects borrowing costs and thus spending & economic activity through credit demand), you’ve flirted with negative interest rates, went on an extravagant asset purchase spree, but nothing worked. So what do you do now? You not only control short term borrowing costs but also the long end of the yield curve. BOJ anchored the short end around -0.2% and the long end around 0% with a +/- 0.1% range by claiming to buy unlimited quantity at the upper end, to keep interest rates low for long. They expected this to maintain the steepness in the yield curve which could help soothe banks’ declining margins as they could now lock in a better spread. It would also support asset prices and build consumer confidence.

Japanese & German Yield curve: Bloomberg
ECB’s Capital Key: % Allocation Breakdown (Source: ECB website)

Now since Draghi has been following the footsteps of Kuroda and is probably in the same boat as him, he also might consider pulling a YCC trick out of his hat considering the end of his asset purchase program in December 2018. He even announced the launch of TLTRO-III (Targeted Longer Term Refinancing Operations) in the March 7, 2019, monetary policy review. Both of which, could help maintain an upward sloping yield curve and low yields.

The biggest beneficiaries of the asset purchase program and TLTROs are usually the nations which have the highest holding the ECB’s capital key with Germany, France, Spain & Italy being the top contenders.

For those who aren’t aware of the TLTRO program, here’s a brief explainer from the ECB website.

Since Germany is going to be one of the biggest beneficiaries of TLTROs as mentioned earlier, we can expect further easing in the nation, while interest rate risk from hikes seems to be subdued for the rest of the year. (Interpreted from the market-implied probability of interest rate changes).

Since the setup for Germany is ready now, considering soft inflation, low-interest rate risk, upward sloping yield curve & negligible credit risk (AAA rated), we can employ a strategy known as “Roll Down” or “Rolling down the yield curve” to enhance our returns within a short horizon of 1 to 3 years rather than just blindly accepting a 0% or even negative YTM on short-dated bonds by just holding them till maturity.

The strategy involves the purchase of a bond with a maturity in the higher yielding section of the yield curve and selling the bond prior to maturity when it reaches a lower yielding section.

Riding the Yield Curve (Source: Bloomberg, Balance Sheet Solutions)

The strategy can benefit investors by providing:

1. Higher incremental income: Purchasing bonds with a higher current yield

2. Higher capital appreciation through liquidation: Depending on the characteristics of the bond, a capital gain or reduced capital loss

3. Diminishing bond price volatility: As the bond moves close to maturity, the duration (interest rate sensitivity) of the bond also reduces.

In order to demonstrate how effectively this strategy has played out in the past one year on the German Sovereign curve, we need to discover the steepest section of the yield curve as on 10th March 2018, which we shall roll down from.

German Sovereign Yield Curve as of 10th March 2018 (Yellow) & 10th March 2019 (Green): Bloomberg

Just from eye-balling, we can deduce that the 5Y Yield at 0.008% and 4Y Yield at -0.23% seems to be steep enough for our strategy. So according to the strategy we buy the 5Y German Bund on 10th March 2018 with a YTM of 0.008% and 0% coupon at a price of €99.958.

5Y German Sovereign Bund, OBL 0 04/14/23: Bloomberg

In our base case, considering no change in rates across the curve, the yield on this bond should slide towards -0.23% leading to a price appreciation of €0.992 or 0.9924% within a span of one year. However, due to changes in the yield curve, we may incur capital gains/losses. In our case, it is observed that the yield on the new 4Y German Bund has moved down further to -0.44%, leading to a total price appreciation of €1.86 out of which as we calculated earlier €0.992 is attributable to the roll down effect and the rest €0.87 gain is on account of the yields moving down.

German 5Y to 4Y Bund Price Movement (OBL 0 04_14_23): Bloomberg

Adversely, yields could move higher if global growth picks up and inflation/IIP data delivers a shocker. We can model these scenarios for the next year by estimating the volatility of interest rates and running a sensitivity analysis of our total returns to these yield curve changes. This interest rate risk can then be effectively hedged with Out-of-the-Money (OTM) interest rate options, thus, locking in an effective gain of close to 0.9924% (after deducting the option cost).

Strategy’s sensitivity to interest rate changes (Source: Bloomberg, Author’s calculations)

As we’ve seen with this example, it is possible to generate positive returns that outperform the broader market by playing with the yield curve dynamics. As they say, it’s all about finding positivity (returns) when you are surrounded by negativity (yields).

Note: This information has been provided by Harsh Shivlani (Department Head, Fixed Income & Derivatives, Finvert) and is for informational purposes only. It is not intended to provide legal, accounting; tax, investment, financial or other advice and such information should not be relied upon for providing such advice.

Author
Harsh Shivlani
Team Leader– Fixed Income & Derivatives
(M.Sc. Finance, NMIMS – Mumbai. Batch 2018-20)

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