A different take on India

Market Update

Inflation was the key macro release of the week. U.S. headline CPI came in slightly hotter than expected, with the annualized number coming in at 3.7%, above consensus estimates of 3.6% and up from July’s 3.2%, mostly driven by energy prices as oil rises. Core CPI increased 0.3% over the month, above consensus estimates and July’s 0.2%. The annualized figure was in line with consensus at 4.3% and down from July’s 4.7%, with goods prices down while services remained firm. Yields fell after rising over the week, while equities were mixed amid muted trading. Market expectations for the Fed to hold at next week’s FOMC meeting did not adjust, and we do not change our view that the Fed has finished hiking.

In geopolitical news, the G20 meeting just concluded in New Delhi, showcasing India’s role as a growing global power and highlighting its ability to bring together developed and emerging economies around a consensus, all while navigating tensions between the U.S. and China. As India’s influence in an increasingly fractured world continues to grow, many global investors are beginning to look at Indian markets as a distinct portfolio allocation.

A different take on India

By now most investors are familiar with the long-term rationale for investing in Indian equity markets: demographics, a growing middle class, and digitalization. While these are certainly valid points, there are other compelling reasons to consider a distinct investment into Indian markets. First, India is one of few emerging markets (EM) where equity investors actually get rewarded for underlying economic growth. In other words, company earnings (and thus the index) tend to grow in line with GDP. This sounds logical and somewhat basic, but most investors would be surprised to learn that is not the case for a large swath of emerging markets, where earnings have not grown in line with underlying GDP. There are several potential reasons why this could be the case, including weak corporate governance, share dilution, index composition, or simply an overstatement of actual GDP growth. What this means is that investors in emerging markets – many of whom invest for the high growth prospects – are not being rewarded for that growth. The benefits of economic growth, even if being felt by companies through higher revenues, are not accruing to shareholders. 

India stands out as an interesting example within EM. Corporate earnings at the index level have closely tracked India’s nominal GDP growth over the last 20 years. While this simple relationship holds across many developed markets, it is relatively rare across EM. Furthermore, assuming this relationship holds, forecasting long-term equity returns becomes more a factor of estimating long-run potential nominal GDP growth. This is another area where India stands out. According to the IMF, India is expected to grow at over 8% annually (nominal) through 2030. This high expected growth rate is based on a number of factors, including a low per capita GDP that allows for significant catch-up growth potential. But a big factor is India’s demographic outlook. Among countries that went through demographic cycles with a period of booming labor supply, there is a clear pattern of high growth during periods when labor supply was expanding as a share of population. This makes sense: if more people are available to produce goods and services, overall output increases. India is expected to see continued growth in labor supply until the 2030s, giving it a long runway to see sustained high rates of growth. 

India in a portfolio context

At a time when China’s growth is structurally slowing, it becomes more important to find pockets of EM that are less correlated to the Chinese economic cycle. Since the Global Financial Crisis, China has become a much more dominant influence on the global economy, but especially within EM. China is the largest source of trade demand for many key EMs such as Korea and Taiwan due to its large appetite for semiconductors, but also as the largest importer and consumer of many major commodities making it is a key driver of commodity prices, along with the overall cycle for commodity exporters such as Brazil and South Africa. Indeed, in many ways EM are highly correlated with the China cycle.

India stands out because it has some of the lowest exposure to China’s economy from a trade and growth perspective, with China only accounting for 0.5% of Indian export final demand. As a large exporter of services, India has a diverse market for exports, and is more correlated with the U.S. cycle than to its neighbor. Furthermore, India stands out in terms of overall exports as a share of GDP – it is among the lowest of the major emerging markets, as the economy is largely driven by domestic demand. With global growth set to slow as the U.S. economy finally downshifts, combined with concerns over the European outlook, India offers high growth potential with lower exposure to global risks. Furthermore, with China’s imports demand structurally slowing, India stands out as a pocket of growth with less exposure to China’s slowdown. This lack of correlation stands out in equity market performance – Indian equity markets are among the least correlated to China, whereas most major EM markets are more correlated. Indeed, given China’s size in the EM index, even the broad EM complex is largely driven by China. For investors looking for high growth with less correlation, India is noteworthy.

An impressive long-term track record

Over most relevant investment time frames, the Indian equity market (MSCI India) is amongst the most consistent and best performing global indices. An equally surprising factor to most investors is that these impressive equity returns have largely been driven by a long track record of relatively consistent compounded earnings. In fact, the 20-year compounded average growth rate (CAGR) for MSCI India earnings is 10.9%, largely matching the 20-year annualized equity return of 14.9% (in local currency) for the equity market.

Over the next few years, we believe that earnings for the Indian equity market can sustainably grow at a low to mid-teens annualized growth rate, above the 20-year average. In fact, earnings estimates for India have recently started to inflect higher and are now expected to grow by 20-22% in 2023, leading us to raise our June 2024 MSCI India target to 2,285 – 2,430, implying 2-8% total return from current levels. We are turning overweight and believe clients with a medium-term investment horizon may consider building a strategic allocation to Indian equities.

A deeper dive into Indian equities

One of the main reasons for the close relationship between nominal GDP growth and the equity market is the heavy weight towards financials. Given that economic growth typically goes hand in hand with the pace of credit and the level of interest rates, there is a relatively tight-knit relationship between GDP growth in India and equity market fundamentals. 

Importantly, we are positive on the financial sector in India for the following reasons:

1. Low penetration of standard retail financial products. The use of consumer credit in India remains low, with standard categories such as mortgages, unsecured credit, vehicle financing, and credit cards meaningfully below international peers. According to World Bank data as of 2021, credit card ownership for the population over 15 years old in India sits at just 5% versus China at 38%. We see a long runway for penetration to approach other EM peers across most retail financial products in India and benefit financial institutions in India in the form of higher loan growth.
2. Corporate deleveraging is coming to an end. After a corporate credit binge after the financial crisis, there was a material non-performing loan (NPL) cycle that began in 2016 and peaked in 2018. This led to several structural reforms that include the consolidation in the number of public sector (government-owned) banks from 27 to 12, and the introduction of insolvency and bankruptcy laws. Corporates now know that they can lose their company or assets if they do not repay their loans. After a multi-year period of deleveraging in the corporate sector in India, borrowing has started to grow with the improved economic outlook – namely from growing foreign direct investment and ‘friend-shoring’ initiatives.
3. Asset quality was maintained at a systemic level through the COVID-19 disruption. 

Valuation for the Indian equity market is a highly debated topic by investors given that forward price-to-earnings (P/Es) are currently higher than the historical average. However, it is worth noting that even with the material valuation compression across global equity indices in 2022, the Indian equity market did not correct back to the historical average. Looking forward, the structural outlook for India does seem better than the recent past, for several reasons:

1. A likely sustained increase in foreign direct investment due to U.S.-China tensions and a redirection of supply chains benefitting India.
2. Corporate de-leveraging is complete and is only just starting to grow.
3. Structural reforms in the banking sector that improve the sector’s profitability and lower risk.
4. Business-friendly policies that include lowered corporate tax rates, and preferential rates to set up manufacturing facilities in India.

Collectively, these could drive low to mid-teens earnings CAGR over the next few years and justify the valuation premium versus history. Overall, we view the current valuation for the Indian equity market as fair, with earnings growth expected to drive Indian equities higher over time.

Risk considerations

Over the shorter term, there can always be cyclical factors that give rise to volatility in equity markets. For Indian equities, higher oil and food prices are typically negative due to the impact of higher inflation on consumer spending. The Reserve Bank of India’s mandate of targeting inflation at 4% could also lead to a tightening in monetary policy, dragging growth. The structurally higher inflation in India typically translates into a ~2% annual depreciation of the Indian Rupee versus the U.S. dollar. The Indian general election is expected to take place in April-May 2024, and any news flows that imply a lower chance of Prime Minister Modi being re-elected could be negatively received. Such pullbacks are opportunities for investors to add to their long-term Indian equity holding, in our view.

Investment approach

Most clients have close to no allocation to India in their portfolios. For the reasons outlined above, a long-term Indian equity allocation could play a useful role as a diversifier and source of long-term returns. In terms of sizing, it could be informative to consider EM and global equity indices, of which India is a notable component (14% and 2% respectively). In line with our long-term positive view on the market, India could potentially make up 3-5% of a globally diversified equity portfolio. In terms of investment approach, active management is important. The task is to identify long-term outperformers, and India historically had more of these than other emerging Asian equity markets.

All market and economic data as of September 14, 2023 and sourced from Bloomberg Finance L.P. and FactSet unless otherwise stated.

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RISK CONSIDERATIONS 

• Past Performance is not indicative of future results. It is not possible to invest directly in an index.
• The prices and rates of return are indicative as they may vary over time based on market conditions. 
• Additional risk considerations exist for all strategies. 
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