Market Update And View Dec2008

December 2008

Fixed Income Summary and View

Summary • 2 contrarian forces – one inflationary and the other deflationary have been in play since last year – Strong demand from emerging economies leading commodities higher and fuelling inflation worldwide – Housing led credit crisis in the US starting to exert a ‘deflationary’ force

• The first force was dominant till early July 2008 leading commodity prices to fresh peaks and inflation to multi year highs. Since then, however, the second force has conclusively taken hold • As a result commodity prices have fallen 50% from the top, growth and inflation numbers are toppling worldwide, and central bankers have shifted focus to achieving financial stability and protecting growth

Inflation Is Falling Across The Globe… 150

500

COMMODITY PRICES

• Commodity prices peaked in July 2008 and are down by more than 50% since then

140

450

130 120

400

110 350

100 90

300

70

250

60

GENERIC COMMODITY INDEX

Nov-08

Oct-08

Sep-08

Aug-08

Jul-08

Jun-08

May-08

Mar-08

Apr-08

50 Feb-08

200 Jan-08

• The intensity of the fall indicates the strength of the ongoing de-leveraging process

80

CRUDE PRICE

Source: Bloomberg

• In line with the above, inflation is falling at a sharp pace in almost all major economies across the world

10.5

PRODUCER PRICE INDEX

10 9.5 9 8.5 8 7.5 7 6.5 6 5.5

EUROZONE

UK

30-Sep-08

31-Aug-08

31-Jul-08

30-Jun-08

31-May-08

30-Apr-08

31-Mar-08

29-Feb-08

US

31-Oct-08

5 4.5 31-Jan-08

• Recent data has sparked serious threat of deflation in the US

CHINA

Source: Bloomberg

…As Growth Collapses 13

5

GDP

12.5

• Major economies like the US, UK, Euro Zone, Japan, Hong Kong and Singapore are witnessing a significant slowdown in growth

4.5 4

12

3.5

11.5

3

11

2.5 10.5

2

10

1.5

9.5

1

9

0.5

8.5

CHINA

US

Sep-08

Jun-08

Mar-08

Sep-07

Mar-07

Dec-07

-0.5 Jun-07

8

EUROZONE

Source: Bloomberg 64

PURCHASING MANAGERS' INDICES

62 60 58 56 54 52

31-Oct-08

30-Nov-08

30-Sep-08

31-Jul-08

31-Aug-08

30-Jun-08

31-May-08

30-Apr-08

29-Feb-08

31-Mar-08

31-Jan-08

31-Dec-07

30-Nov-07

31-Oct-07

30-Sep-07

31-Jul-07

31-Aug-07

30-Jun-07

30-Apr-07

31-May-07

46

31-Mar-07

48

28-Feb-07

50 31-Jan-07

• Lead indicators are pointing towards further contraction around the world (including in China)

0

44 42 40 38 36 34 US

EUROZONE

UK

CHINA

Source: Bloomberg

Policy Response Has Been Unprecedented • The US Fed has been proactive in cutting rates given that the US has been the epicenter of the current crisis

8

POLICY RATES

7.5 7 6.5 6 5.5 5 4.5

• Most Asian central bankers, most notably the Peoples Bank of China, have started cutting aggressively as well

4 3.5 3 2.5 2 1.5

US

EUROZONE

UK

CHINA

Source: Bloomberg

28-Nov-08

31-Oct-08

30-Sep-08

29-Aug-08

31-Jul-08

30-Jun-08

30-May-08

30-Apr-08

31-Mar-08

29-Feb-08

31-Jan-08

31-Dec-07

30-Nov-07

31-Oct-07

28-Sep-07

31-Aug-07

31-Jul-07

29-Jun-07

31-May-07

30-Apr-07

30-Mar-07

28-Feb-07

1 31-Jan-07

• Inflation targeting Central Bankers of Europe have also shifted stance. UK has cut drastically recognizing the catching up required

A Similar Theme is Underway In India… 13.0%

• Wholesale Price Index (WPI) inflation has fallen drastically over the past few weeks in line with global trends

12.0% 11.0% 10.0% 9.0% 8.0% 7.0% 6.0%

• We expect it to fall to below 3% levels by March 2009

5.0% Projected Inflation

4.0% 3.0% 2.0%

Jan-09

Sep-08

May-08

Jan-08

Sep-07

Jan-07

May-07

Sep-06

Jan-06

May-06

Sep-05

Jan-05

May-05

Sep-04

Jan-04

May-04

Sep-03

Jan-03

May-03

Sep-02

Jan-02

• GDP growth is decidedly slowing despite support hitherto from the services sector

May-02

1.0%

Source: Bloomberg & HSBC AMIN research 11

GDP

10.5 10 9.5 9 8.5 8 7.5

GDP

Source: Bloomberg

30-Sep-08

30-Jun-08

31-Mar-08

31-Dec-07

30-Sep-07

30-Jun-07

31-Mar-07

31-Dec-06

30-Sep-06

30-Jun-06

31-Mar-06

31-Dec-05

30-Sep-05

30-Jun-05

7

…With Further Weakness Ahead 50 48 46 44 42 40 38 36 34 32 30 28 26 24 22 20 18 16 14 12 10 8 6

EXPORTS

31-Oct-08

30-Sep-08

31-Aug-08

31-Jul-08

30-Jun-08

31-May-08

30-Apr-08

31-Mar-08

29-Feb-08

31-Jan-08

31-Dec-07

30-Nov-07

31-Oct-07

30-Sep-07

31-Aug-07

31-Jul-07

30-Jun-07

31-May-07

31-Mar-07

• Monthly growth indicators like trade data and purchasing managers’ index point to sharply lower prints in incremental GDP numbers

30-Apr-07

• Relative freeze in domestic credit markets has happened starting October 2008

TRADE

IMPORTS

Source: Bloomberg 60

PURCHASING MANAGERS' INDEX

58 56 54 52 50 48 46

31-Oct-08

30-Sep-08

31-Aug-08

31-Jul-08

30-Jun-08

31-May-08

44

PURCHASING MANAGERS' INDEX

Source: Bloomberg

Policy Has Been Proactive 11

10

• We expect more rate cuts ahead given the need to anchor overnight rates at much lower levels in order for banks to ‘feel the steepness’ • The 1 yr swap rate is already pricing in overnight rates of below 5% • Government security yields have fallen but still look lucrative as rate cuts should continue

8

7

REPO RATE

1 YEAR OIS

28-Nov-08

31-Oct-08

30-Sep-08

31-Jul-08

29-Aug-08

30-Jun-08

30-May-08

30-Apr-08

31-Mar-08

29-Feb-08

31-Jan-08

31-Dec-07

31-Oct-07

28-Sep-07

31-Aug-07

31-Jul-07

29-Jun-07

31-May-07

30-Apr-07

30-Mar-07

5

30-Nov-07

6

31-Jan-07

• However, while bank lending rates have been cut in response, flow of credit is still to resume fully

9

28-Feb-07

• Policy makers have been quite proactive so far with monetary as well as other administrative tools

RATES

10 YEAR GOVERNMENT SECURITY

Source: Bloomberg

Excess Supply Is No Longer A Worry • Government will breach its fiscal target for the year, in line with our long held view • However, given rising delinquencies on loan books and trader appetites already whipped by a sharp rally so far, the additional supply will be comfortably absorbed • RBI is already committed to providing liquidity for incremental borrowing through simultaneous buy-back of market stabilization bonds • The opening up of spread between government securities and the swap curve partly reflects expectation of additional supply. • The government securities curve still provides a lucrative entry point as it might gear up for the next leg of rally when fears around absorption of incremental excess supply are decidedly eliminated.

Credit Spreads May Still Compress Reluctantly

11 10 9 8 7 6 5

Mar-08

3

CREDIT TO GDP RATIO (%)

Source: Bloomberg 118 117 116 115 114 113 112 111 110 109 108 107 106 105 104 103 102

800 750 700 650 600 550 500

ASIAN CURRENCIES AND EMERGING MARKET BOND SPREADS

ASIA DOLLAR INDEX

Oct-08

Nov-08

Sep-08

Jul-08

Aug-08

Jun-08

Apr-08

May-08

Mar-08

Feb-08

Jan-08

Dec-07

Nov-07

Oct-07

Sep-07

Jul-07

Aug-07

Jun-07

Apr-07

May-07

Mar-07

Jan-07

450 400 350 300 250 200 150 100 Feb-07

• With equity markets being weak and banks less willing to lend, the process of channeling domestic savings into investments has been disrupted as well

Mar-07

Mar-06

Mar-05

Mar-04

Mar-03

4

NON FOOD CREDIT (INR CRS)

• The current risk aversion (as reflected in rising emerging market bond spreads and weakening currencies) has led to severe fall in external sources of funding

13 12

Mar-02

• A sustained current account deficit during this time has meant we have consistently relied on external funding

14

INDIA'S PHENOMENAL CREDIT CYCLE

Mar-01

• India has had a phenomenal credit cycle with the stock of credit having doubled over last 3 years

500000 475000 450000 425000 400000 375000 350000 325000 300000 275000 250000 225000 200000 175000 150000 125000 100000 75000 50000

EMERGING MARKETS' BOND SPREADS

Source: Bloomberg

Credit Spreads May Still Compress Reluctantly (cont) • All this means that demand for funds far outstrips supply as of now. As long as this is the case, it is unlikely that there will be any meaningful compression in spreads • Some stability in international risk appetite (and in turn currency) may lead stabilization in corporate spreads domestically since it may open window for external funds again • A sustained contraction in spread will, however, only happen once demand versus supply of credit finds a better balance than currently • Consequently, current strategy favors government securities in building duration. At some point, however, as triggers mentioned above begin to fructify we will go overweight corporate bonds

Income Fund returns during the last cyclical bull run • The last secular bond bull run lasted approximately 3 years beginning October 2000 • Average returns of of 17 income funds which were in existence over this full period were: Year 1 = 16.9%, Year 2 = 16.6% and Year 3 = 7.9% (all returns post expenses)* • Average returns over the 3 years was 13.8% (post expenses) • There are 2 inferences to be made: – Duration play can potentially be much more powerful than play on credit risk – One needs to stay invested over the period of a cycle in order to benefit fully from a fall in interest rates

*Source: MFIE, HSBC AMIN Research

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