Cornerstone Capital’s regional strategy model is overweight the MSCI Emerging Markets Asia Index, which includes the major stock markets in the region, most notably China (29% of the index’s market cap), South Korea (25%), Taiwan (19%) and India (11%). Over the past twelve months, India has been by far the strongest performer of these four markets, both in dollar and local currency terms.
A key reason for India’s strong performance has been investor enthusiasm following Narendra Modi and the BJP party’s sweeping victory in the recent national election. Specifically, the hope is that the process of structural reform can be accelerated, at the same time that India’s economy continues a cyclical rebound.
A CYCLICAL ECONOMIC REBOUND
Until the 2012 fiscal year (ending in March 2012), the Indian economy had grown at 8% per year for nearly a decade. In fiscal 2012, however, real GDP growth was just 4.8%. Observers blamed this sharp decline in growth on policy paralysis by a fractured coalition government. Three factors are pointed to:
• First, corruption scandals involving the ruling Congress party led to the jailing of several of top-level politicians and bureaucrats. (A former Indian railways minister was sentenced to five years in prison in 2013 after being found guilty of embezzling state funds.) This resulted in policy gridlock because, worried about the risk of being accused of corruption, many government officials put off making decisions.
• Second, the environment ministry delayed decisions on environmental clearances for projects worth more than a hundred billion dollars. Approving environmental clearances go to the heart of a long-standing dilemma in India: how to develop quickly in a country still plagued by poverty while minimizing damage to the environment.
• Finally, an ineffective prime minister’s office slowed things down even more by failing to coordinate across ministries. (Most decisions in India require agreement among two or more ministries e.g., the oil ministry and the environment ministry.) It’s also arguable that sensible policy-making was constrained by coalition politics.
Even before Prime Minister Modi has initiated any major reforms, the outlook for India’s economy has been improving, with a consensus expectation for 5.4% real GDP growth in fiscal 2015 and 6.1% in fiscal 2016, up from 4.7% in fiscal 2014 (ending in March 2014). Recent data suggest a rebound in industrial production and merchandise exports. Economists also point to a potential improvement in the investment cycle reflecting greater confidence about the long-term outlook for India’s economy.
Indeed, if India’s economy can grow at 10% per year over the next two decades an entirely feasible ambition by 2030 it would be the world’s third-largest economy. There are three reasons why such growth is possible:
1. Throughout the last decade, India’s national savings rate has been consistently at 30% of GDP or higher. Those savings imply that India has plenty of investible resources to grow the stock of capital, an important ingredient in growth.
2. Demographically, India is young, and it is predicted to become even younger, with a healthy growth in population. It will not, therefore, face the labor shortages that have already hit many other economies, including China.
3. Finally, with a per-capita income of around only $1,500 per year, India still has a lot of catching up. In particular, it remains well below global productivity averages, so that the economy can grow rapidly as productivity improves.
Improved governance is a big promise of the new government. Mr. Modi has a reputation for being a good administrator and his strong governance is known to be a significant factor behind the Gujarat “success story”. Modi campaigned on his record as chief minister of Gujarat state, one of the richest states in India.
Better governance is desperately needed in India. The country ranks as by far the worst in terms of corporate governance among the major economies in Emerging Asia – Figure 1. (The Emerging Asia region itself ranks well below the developed regions of Europe and North America.)
Restructuring bureaucratic processes and cutting red tape appears to be part of Modi’s agenda. Empowering the bureaucracy to work effectively, after the setbacks due to recent corruption scandals, will be an important goal too.
The odds of better governance in India are high because, for the first time in the country’s modern history, a non–Congress Party outsider with no prior involvement in running the central government won an absolute majority in parliament. Moreover, it’s likely that Modi wants to be transformational and aspires to remain in office for multiple terms.
A SUPPORTIVE OUTLOOK FOR INDIAN EQUITIES
The outlook for Indian equities likely remains supportive. GDP is a key driver of corporate profits in India and, as noted, GDP estimates have started to trend up. Moreover, given current low capacity utilization rates and margins near historic lows, a modest improvement in profit margins could result in a meaningful boost to earnings.
In terms of valuation, the Indian market is currently trading at around 15x one year forward earnings, which is in line with historical averages. If Mr. Modi delivers even partially on his reforms agenda, that structural improvement coming on top of a cyclical economic recovery could well result in P/E multiple expansion.
Michael Geraghty is the Global Markets Strategist at Cornerstone Capital Inc. He has over three decades of experience in the financial services industry including working as an investment strategist at UBS and Citi.