Indian equities are among the best performing in emerging markets in US dollar terms this year, with the MSCI India Index delivering 23% from January to the end of July.
As the newly-elected Narendra Modi government completes the first 100 days in office, it is an opportune moment to do a reality check on whether this is a sign of better times to come.
2014 has seen foreign investors increasing their allocation to Indian equities leading to inflows of about $12 billion to date. The first signs of revival of interest from domestic retail investors in equities after an absence of six years, as seen by inflows of $3 billion into domestic mutual funds over the past three months, could be crucial for the next leg of the rally.
Domestic flows would also provide support in case of any foreign investors selling as and when the US Federal Reserve starts raising rates. Valuations at 16-17x FY15 earnings are reasonable and around the average which India has traded at. And RoEs for Indian companies currently at 16-17% have a scope to expand as economic growth picks up and operating leverage kicks in.
No quick fix
The India story in the previous decade had three key drivers – consumption, infrastructure investments and exports. Various corruption scandals caused decision-making in the previous government to come to a standstill. Approvals for several projects got stuck, adversely impacting infrastructure investments. Supply-side shortages caused by lack of investments led to double-digit inflation, hurting consumption. GDP growth slumped to 4-5% from 8-9% earlier.
It was against this backdrop that people gave a mandate to the pro-growth oriented Modi-led Bharatiya Janata Party that promised “more governance less government.”
Given the complexity of the Indian economy and politics, there is no magic wand solution in sight to get the economy back on track overnight. We have already seen proposals for increasing FDI in insurance or modifying the archaic labor law stall because the government lacks a majority in the upper house of parliament. A uniform value-added tax for goods and services, which industry has been clamoring for, will require consent from state governments. The government will need to slowly work through this maze to get these changes implemented.
But some quick fix reforms like FDI in defense and railways have been cleared by the government. It is looking at faster environmental clearances for projects and resolving problems on coal linkages for power to get the investment cycle moving.
The buoyant equity markets are also helping corporate India to deleverage. These factors would help tackle the problem of non-performing assets, especially at public sector banks, and free up more capital for lending.
The fact that there is meeting of minds between the finance ministry and the RBI, India’s central bank, on the goal of bringing down inflation is a positive. The government’s commitment to maintain fiscal deficit at 4.1% of GDP for this year, though optimistic on revenue projections, shows the intent of the government to keep its house in order. This would pave the way for a sustainable low interest rate regime to the benefit of both the consumer and industry.
Near term correction?
There will definitely be turbulence on the way due to problems in the Middle East causing a flare up in oil prices, Janet Yellen deciding to hike rates, Russia becoming more belligerent or concerns of a debt default in Latin America or Europe.
But a revival in economic activity would help domestic-oriented themes like infrastructure or consumption. And as the global and US economy comes out of its slumber, export-oriented sectors like IT would also benefit. The longer-term story for Indian equities is looking stronger.
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The top five performing India-focused funds over the past five years have outpaced the lackluster index, which has recovered strongly in 2014.
