Bonds look much more attractive than stocks: Sonal Desai

Sonal Desai, chief investment officer, Franklin Templeton Fixed Income Group, said the US Federal Reserve wants interest rate increases to be done but is in no position to cut rates on account of inflation. In an interview with Nishanth Vasudevan on the sidelines of the firm’s conference in Hong Kong last week, Desai, who oversees $124 billion in global fixed income assets, spoke on her outlook for Indian bonds among other topics. Edited excerpts:

What is your assessment of the US Fed’s policy direction after last week’s meeting?

It’s pretty clear that the Fed wants to be done. And they might well be. The real question to me is does the Fed decide not to raise and then just hold firm. That is something it needs to do because whether people like it, or not, the underlying inflation is still in the system and is real. It’s not huge, but it’s enough. And if I look at wages, the Atlanta Fed wage growth monitor is at around 5%. This is not consistent with the Fed’s 2% inflation. The Fed recognises this. There are expectations that rate cuts could start from June next year. That’s probably too soon and I’m not sure the economy would have slowed enough by June for them to be confident enough to start cutting.

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So, in terms of numbers, what are your expectations from the Fed?
To be fair, you would need a serious surprise on the upside on inflation, to make them raise rates further. It’s just that you can’t rule that out yet. A full year at 5.25% to 5.50% (Fed Funds Rate) will come as a shock to the markets. Probably, the Fed might cut in Q4 of next year for the first time by around 25 points. I can’t predict how long or how quickly they will cut rates. Maybe if you don’t have a recession, the Fed might cut once a quarter. If they see a recession, they will cut faster, but without a recession, they might cut once a quarter. But I don’t think the Fed will take rates all the way down to 2.5%. There’s no reason to do that.

How are you assessing bonds against stocks with Treasury yields touching 5% recently?
Bonds are looking much more attractive than equities. As a fixed income investor, times are good. Even with my outlook on rates, it is a time to start putting in long durations. So, you will start taking some benefits from this bet when the Fed cuts rates. Whether it cuts in June or September or December or the fall doesn’t matter, because in the meanwhile, I keep clipping coupons. I buy the best quality investment grade bonds, and I get 6%- plus in income. In the case of equities, US earnings growth is a consensus 12% next year and that feels optimistic. Where does the 12% come from? Ultimately, there’s an internal cognitive dissonance. Bond markets should be rallying if we expect the US to slow and if you expect the US to slow, where does the 12% happen? So, we’ve repriced a lot in bond markets, but equity markets are yet to be repriced.

Wall Street commentators are increasingly highlighting the risk of the US fiscal policy spinning out of control. Your thoughts.
The reason that we have not seen anything on US fiscal policy since the global financial crisis was that it was never a problem. Any fiscal policy was enough because there was no inflation, growth was mediocre and the Fed was basically buying all the excess issues. Now, a few things have happened together recently. Last year, the fiscal deficit was around $1 trillion, which was 5.3% of the GDP. That’s a huge number. And then this year, with unemployment remaining at 40-year lows, the fiscal deficit came in at $2 trillion. So, the deficit is definitely a concern and people are focused on it. The Fed could manage the situation when there was no inflation and it is unable to do that. All the smoke and mirrors only work in a perfect scenario where you don’t have inflation, you don’t have too much growth and unemployment is low, but it’s not too low. To some extent, the remaining hope that somehow the Fed can come in and cut rates goes away.The gap between India’s 10-year and US 10-year bond narrowed to about 250 basis points. Is that enough?
For a country whose fundamentals are improving, such as India’s, it can be enough. It doesn’t have to be or may not be. If the fiscal disappoints in India, the 250 (bps) gap may prove to be insufficient. So that’s something one has to keep an eye on. Next year will be an election year in India and it’s not the right type of environment, much like the US fiscal policy. So we have to see how fiscal policy evolves. On the positive side, there is the famous inclusion into the different bond indices. Currently, the foreign take up of the securities is around $12 billion. It could increase to up to $20 to $24 billion on the back of JPMorgan and Bloomberg index inclusions. So those are positive drivers. But, if you look at the overall amount of $20 to $24 billion, it’s not massive in global asset manager portfolios, but it is important for the Indian bond market from the perspective of additional new demand. I do think that the stars are aligned for India in the sense that you have external factors, such as the geopolitical tensions with China, leading to a new desire to have India as a counterweight from the perspective of a manufacturing hub. India has had many false dawns but I’m optimistic that it will be able to get to the other side this time.

Do you see value in India’s long-term bonds?
We do find them attractive and we are looking to increase exposure. Majority of the funds I oversee are basically US domiciled and US-focused funds. But we are taking exposure wherever it’s possible in our emerging market funds, and others. You will find that in the runup to the inclusion, Indian bonds could start seeing the flows trying to pre-emptively come and take advantage. There are still about 10 months to go before that but overall, I’d be quite optimistic about the outlook.

(The reporter was in Hong Kong at the invitation of Franklin Templeton)

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