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The prospects for investors in India

The largest election the world has ever seen has been run and won in emphatic style. India will be governed by Narendra Modi’s Bharatiya Janata Party for the next five years after his coalition scored the biggest election win in 30 years, securing 61% of the seats. Voters tired of corruption, bureaucracy and slowing growth have ousted the Ghandi dynasty, whose Congress Party had dominated politics since independence. Such a strong mandate will be an inflexion point for India’s growth story, which has been hamstrung by bureaucracy for the last five years.

Under the Congress Party, red tape strangled growth and stalled critical infrastructure projects. Gross domestic product (GDP) growth slowed from 11.4%, annualised, in the March quarter 2010 to the latest reading of 4.6%, whilst recent inflation, as measured by the Wholesale Price Index, has averaged 7.9%. Structural impediments that widened the twin deficits also meant India’s reflexivity with the global economy increased.

India now has the opportunity to move from a period of stagflation to become a self-fuelled growth story independent of the global economy. Investors and locals alike appear universally positive that Modi’s pro-growth and reform platform can reverse the previous policy paralysis and quickly return GDP growth to the 6-7% level. Such goals appear achievable through infrastructure investment, clearing growth bottlenecks and productivity gains from the power and oil sectors, which should help to revive consumer sentiment. Additionally, with only 2.5% of India’s exports being raw materials to China, the growth trajectory should be unaffected by any slowdown in Chinese investment. All of this makes India a compelling case to be the best performing market in Asia on a three- to five-year view. However, it is not without its challenges.

A growth rate closer to 8% will require difficult supply side reforms. But here Modi has some runs on the board. As Chief Minister for Gujarat during the last 12 years, Modi has put through reforms, courted foreign companies, developed infrastructure, built free-trade zones, irrigated agricultural land, increased the operating efficiency of state companies and reduced poverty. Agriculture was a key focus that had significant success with crop yields increasing by 30 to 300% during the last decade. The net result is that Gujarat has had GDP growth of 10.4% per annum during the last five years compared to 6.4% per annum for the nation.

In his first month in office, Modi has not put a foot wrong, providing the market with incremental evidence that his policies are not just talk but will be actioned and perhaps at a faster pace than expected. Measures executed thus far include reducing cabinet numbers by 38% (“minimum government, maximum governance”), creating a fast-tracked project approval process, establishing a ‘bad bank’ to manage public sector banks’ non-performing loans, removing foreign direct investment limits in the defence sector and even easing tensions with neighbouring countries by inviting all heads of states to his inauguration.

Foreign investor inflows have been strong, having been starved of alternatives in emerging markets. Inflows year-to-date amount to US$20.4 billion, more than 1.67x the total inflows of 2013. However, the flows are still slightly skewed towards bonds as opposed to equities. Equity inflows still have potential to significantly increase, driven by rotation out of bonds as well as fresh inflows. During the last two years, the average foreign equity inflows amounted to 15.9% of the market cap, more than double the 7.8% received year to date.

Anecdotal evidence suggests the bulk of the flows have come from Asian equity funds and a small portion from global emerging market funds. Global equity funds are yet to enter the market, having been unwilling to take a bet on an election outcome in a country that is just 0.7% of their benchmark. Now that the election win is confirmed, they need to see evidence that the policies are being put in place. The key evidence of this will come in the form of the Union Budget to be delivered in early July.

But do not expect a V-shaped recovery in the economy. Structural issues take time to resolve. Stalled projects need financing to restart, fiscal discipline will require tightening and monetary policy still remains tight. The budget in particular is difficult to forecast with a long list of potential policies and Modi’s recent declaration that he needs to take “harsh decisions and administer some bitter medicine”.

The biggest near-term risks to the recovery are oil prices and a weak monsoon. With India importing about 80% of its oil requirements, a supply shock from the recent Iraq conflict may send oil prices higher whilst restraining global growth and depreciating the rupee. This would have significant current account implications as well as affecting the government’s ability to remove subsidies and deregulate the sector. A weak monsoon, as predicted by El Nino conditions, will also constrain near-term growth in an economy where two-thirds of the population is rural.

Longer term, the rupee remains a headache for policy makers. High inflation relative to trading partners and no growth in the share of world exports suggests the rupee should be weaker yet it is appreciating driven by inflows. As a result the currency is now estimated to be 6.4% overvalued in real effective exchange rate terms.  Inflows are currently limited to portfolio inflows and remittances from foreign workers. However, if foreign direct investment regulations are relaxed, as they have been in the defence sector already, inflows could accelerate creating additional appreciation pressure. The Reserve Bank of India (RBI) seems to have learnt from its mistakes in the post-Global Financial Crisis period when it let the currency appreciate to the point where it caused economic stress. The RBI appears to have drawn a line in the sand around the Rs58 per US dollar level which they appear committed to defending.

In the short term, the market may have run too far too fast. The rally has lifted all cyclical stocks indiscriminately, and the market is overbought on most metrics. There will be some lag between a pickup in corporate earnings, with most companies suggesting the impact will not be felt until next financial year. With the market likely to become more discriminate and a lack of catalysts ahead of the budget, there could be some consolidation in the near term. Investors should use this opportunity to position for a multi-year growth story.

Stocks and sectors that will have the greatest benefit in the new growth cycle will be those that have suffered the most in the down-cycle. This includes areas such as capital goods, infrastructure, cement, property, auto and banks. Sectors to avoid are telcos as competition increases, IT services and pharmaceuticals if the rupee appreciates and the defensive consumer staples.

 

Casey McLean CFA is an Asian Equities Portfolio Manager/Analyst with AMP Capital.


 

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