Despite its huge potential and outstanding performance over the past 30 years, India remains underrepresented in international portfolios.
2022 is a complicated year for stock markets, including emerging countries, which were down nearly 30% at the end of October. However, there is one market that is holding up quite well. It’s India. In fact, the Sensex lost less than 1% in 2022 in local currency and about -7% in dollars.
Indeed, Indian stocks only magnify the outperformance accumulated over the past 30 years compared to other emerging countries, including China (see chart below).
Graph: Cumulative performance of MSCI India (in green), MSCI Emergig Markets (in blue), and MSCI China (in orange) over the past 30 years
What are the reasons for this disparity in performance, especially compared to China? As Wellington Asset Management explains, “In China, everything is done by the government; in India, everything is done in spite of the government.” While China has largely supported the development of its industry over the past decades, this was not the case with India. With less state support, only Indian companies with sustainably higher returns managed to survive and gain market share. The result: the return on capital for the Indian market is higher than that of other emerging countries.
Can Indian stocks continue to outperform?
Several structural and cyclical factors should continue to support the Indian stock market over the next few years.
1. An appropriate macroeconomic context
The Indian economy’s GDP is expected to grow around 7% for the whole of 2022, a growth rate that should remain at this level for the next few years.
According to Morgan Stanley, India should become the third largest economy in the world by 2027. Its GDP could more than double in 10 years, from the current $3.4 trillion to $8.5 trillion.
Graph: Indian nominal GDP growth as forecast by Morgan Stanley
Among the drivers of this strong growth is a major shift in economic policy away from redistribution in favor of stimulating investment and job creation.
Another element likely to support growth: the current political tensions between the US and China that are prompting companies to diversify their supply chains. India is likely to be the main beneficiary of this trend, and through its ‘Made in India’ campaign, it is making great efforts to attract foreign investment, thus boosting exports of manufactured goods in sectors such as chemicals, industrial machinery, pharmaceuticals and automobiles. A strong workforce of nearly half a billion people, many of whom are highly educated young people, supports this manufacturing momentum. The new factories and service platforms set up by international companies will not only create more jobs but also improve productivity. This is a virtuous circle of growth very close to the East Asian model: an increase in exports leads to an increase in wages and consumption and also in savings which are then recycled into productive investment.
India is also increasing its public spending to offset some of the backlog in terms of hard infrastructure such as roads and railways. But above all, it is in the area of digital infrastructure that India is building its comparative advantage. Unlike other economies that rely on private networks, India has been the first in the world to build public digital infrastructure. This is based on its unique numerical identification system, called Aadhaar.
In terms of inflation, higher energy and food prices did not lead to the price explosion some had feared. Notably, India made the decision not to punish Russia and to become one of its major trading partners (more than 1 million barrels of imported crude oil per day). When the West applied the sanctions, the Indian Oil Minister stated that he had a fiduciary duty to his people to provide energy and food at the best price.
However, the inflation rate increased from 5% to 8% during the first nine months of the year. But it has remained on average below wage growth and appears to be starting to decline.
Graph: Peak inflation (CPI y/y) may be behind us
India has already gone through a deleveraging cycle. As a result, corporate balance sheets are becoming healthier, particularly in the banking sector, allowing credit growth to resume. It appears that the crisis of 2017-2019 involving India’s Non-Banking Financial Corporations (NBFCs) is already over.
Finally, the macroeconomic context is now more favorable to the Indian rupee, even if the value of the Indian rupee has depreciated sharply against the dollar this year. India now has record foreign exchange reserves and a stronger current account balance. Existing foreign exchange reserves indicate that the country will be able to fend off money outflows and avoid excessive currency depreciation.
2. Relative political stability
There is currently no serious opposition to Prime Minister Narendra Modi and his ruling Bharatiya Janata Party. Indeed, Modi appears to have every chance of winning the 2024 elections.
3. Demographics are widely favorable
The median age of India’s population is 28, compared to 38 in the United States and China, 46 in Germany, and 48 in Japan. More importantly, the working-age population is increasing, which leads to an increase in the labor supply, which is a major driver of economic growth.
Urbanization, the improvement of the housing cycle, and the growth of the middle class are all favorable winds for the economy. Over the next 15 years, the urban population of India is also expected to increase by 125 million people. Between 2020 and 2030, the share of household discretionary spending is expected to increase from 24% to 40%.
4. Stock markets: one of the largest and most liquid markets in the region
In terms of market capitalization, India is the third largest stock market in Asia outside of Japan, after China and Hong Kong. It is also one of the most liquid markets in the region. Since the beginning of the pandemic, the market has seen a significant growth in the participation of domestic investors, especially retail investors who funnel national savings into the stock market and provide a buffer against foreign capital outflows (see point 6).
It is also important to note that the segment allocation in the Indian market is changing, with more internet, media and e-commerce companies potentially entering the market in the next two to three years. These two sectors each account for less than 1% of the MSCI India index, compared to 16-18% each for the MSCI China index. But the majority of companies preparing for an IPO fall into these sectors and must eventually change the composition of the index sector.
Graph: The weight of the technology and media sectors in the MSCI India and MSCI China indices
5. A new round of profits for Indian companies
The aforementioned macroeconomic, demographic and geopolitical fundamentals should combine to promote a new round of corporate earnings in India. This coincides with the end of the deleveraging cycle that began in 2015, leaving companies in a much stronger financial position than they were in a few years ago.
The annual earnings growth of companies in the S&P BSE Sensex index for the next three years is expected to be 25%. This means a relative outperformance of about 16% against the broad emerging markets index, which is expected to gain 9% annually (source: Peregrine). Corporate earnings relative to GDP are now on an upward trend after declining for more than a decade. This development is partly due to the reduction of tensions in sectors such as banking and metals. At the same time, the IT and pharmaceutical sectors continue to boost India’s position on the global stage.
6. New enthusiasm for stock markets from locals
Despite the positive outlook mentioned above, international investors seem to be turning away from Indian stocks. But demand from domestic savers largely offsets the lack of foreign inflows. India’s Mutual Funds Association reported net inflows of $2 billion in September, up 17% month-on-month.
Graph: Flows into the Indian stock market from domestic savers of systematic investment schemes
Valuation multiples that remain high
One of the main arguments against investing in this market is the relatively high level of valuation. Note, however, that earnings are now at a 30-year low, which contributes to the current “high” profit-to-price valuation in the Indian market. If corporate earnings improve significantly over the next few years, valuations should normalize.
Historically, investors have undervalued Indian stocks due to India’s underrepresentation in emerging indices (11% while GDP is 45%) and misunderstanding of risks such as market liquidity or concentration.
In the medium to long term, India is expected to benefit from several tailwinds such as digitalisation, growth of direct-to-consumer trade, and geopolitical adjustment of supply chains.
The biggest risk in this market is the significant and continuous rise in commodity prices, which may adversely affect current and financial accounts in India and push inflation higher.
The changes underway in the Indian economy are not fully reflected in the standards. The best way to seize opportunities is to screen companies carefully through both bottom-up and bottom-up research.
Sources: FT, Morgan Stanley, Peregrine, Wellington Asset Management