The emerging factor in Indian markets

Where are Indian markets headed in 2019? The stock answer is that it all depends on the election outcome. That might be an oversimplification. Markets move in packs and India’s fate is tied to that of emerging markets (EM). If EMs fall off the investment map, India is unlikely to produce high asset returns even with a favourable election outcome. On the flip side, a sustained EM rally could set a floor for our local markets even if the political outturn disappoints.

After a weak first nine months, EMs picked up in November last year. There was a rally across asset classes—bonds, equities and currencies—that spilled over to the new year. An index computed by HDFC Bank of EM currencies (a proxy for overall asset market performance) rose by 4 per cent against the dollar between November 2018 and January 2019 after dropping by 5 per cent in the first nine months. However, in February the rally began to peter out.  

The brief EM bull-run was aided by a couple of things. For one thing, the US Federal Reserve (the Fed) softened its stance in October as inflation fears gave way to apprehensions instead of a sharp slowdown in the American economy in 2019. The Fed’s pussy-footing meant that financial markets went from ‘pricing in’ three interest rate hikes to none in 2019. This revived the so-called carry trades with investors borrowing at low interest rates in developed markets to invest in higher yielding EM assets, driving their stock, bond and currencies up. For oil importers in the EM world, softness and stability in oil prices also lent a helping hand.

Sceptics argue that the moderation in February shows that the EM rally was a flash in the pan as investors temporarily had overlooked both the macro-fundamentals and risks of EMs. The American investment bank, BofA-Merrill Lynch that surveyed fund managers earlier this year drew a parallel between this EM boom and the Bitcoin rally in December 2017 that had been followed by a precipitous decline of 80 per cent.

 
There is a strong counterargument that the February moderation was a mere current “correction” that set the stage for another sustained rally. I would go with this view. This hinges on both attractive valuations in EM stock markets and their enduring interest rate advantage over developed markets. Both should invite fresh capital inflows. The benchmark MSCI EM stock index, for instance, is trading at a price-earnings multiple of around 11 (using one year forward earnings) compared to the aggregate MSCI world index of 14.5.

Besides macro-balances — current account and the fiscal gaps — of a number of EMs have shown remarkable improvement since the taper tantrum of 2013 that butchered these markets. A number of them have also risen to the challenge of shrinking global trade. Domestic consumption has improved dramatically even for traditional exporters like Malaysia as demographic profiles have improved. The bottom-line is that with the US slowing down, EM growth will beat that of the developed world hands down and that is reason enough to chase their markets.

Where does India stand in all this?  India’s markets decoupled from the EM pack from mid-December after a brief pop in November. In January 2019, EM stocks and bonds attracted an estimated $51.1 billion of foreign capital, the highest level in the past 12 months. However, there was an outflow of $0.8 billion from Indian debt and equity markets.

Political uncertainty is certainly a factor in this decoupling. Equally importantly, it is difficult to make a strong investment case for the Indian stock markets based on valuations. While projected profit growth of around 20 per cent for Indian companies is strong, the high price-earnings (P-E) multiple of over 17 (China is at 10; Brazil at 11) takes the sheen off a bit. Fiscal slippage on the back of the pre-election ‘populist’ spending binges and the problem with NBFCs seem to have increased the credit risk for Indian bonds.

Going forward, the future of the Indian markets will depend on three things.  First, the election results. While markets have baked in a probability of a coalition government, the exact nature of this coalition is critical. If there is a stable coalition that shuns budgetary extravagance, investors could make a grab for India once again.

Markets do not decouple from their peers permanently and as domestic uncertainty abates, India will climb back on the EM bandwagon. Then it is a question of whether this gathers speed or its wheels come unstuck.  

The relatively high valuations of Indian equities will continue to niggle. However, investors tend to rationalise things like overvaluation if sentiment turns in favour of a market. If indeed they see shrinking global trade and the risk of a sharp deceleration in China as the top two global risks then India offers a high degree of insulation. India ranks poorly on almost all measures of global integration like the OECD-WTO Global Value Chains (GVC) Participation index. That is a big positive if the global trade engine sputters. Again a slew of studies (the widely quoted IMF study, China’s Slowdown and Global Financial Market Volatility: Is World Growth Losing Out? 2016, is an example) shows that India would be the least affected in the Asian region if China’s growth were to fall sharply.

Thus, if politics and peer performance work in India’s favour, the relatively high valuations of Indian stocks could be seen as insurance premium that protects against global trade and China risks. The prospect of a bull market in India post-elections might be quite bright after all.

The author is chief economist, HDFC Bank



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