India’s time to rise: The power of the underdog!

31 Dec 2023 , 07:56 AM

Famous American author, Jenny Han once said, “Victory is a thousand times sweeter when you are the underdog.” Most of us must have felt this way at some point in time or another. A glance at the latest data highlights that India is having one such moment. India’s escalating significance within the MSCI indices indicates its growing influence on the global financial stage. 

Propelled by a host of favorable economic developments, market reforms, and resilient corporate performance, India garnered heightened attention from the global investment community. The MSCI Emerging Markets Index, a widely monitored benchmark, has witnessed an upswing in the allocation of Indian stocks. As per the latest data available, India’s representation in the MSCI Emerging Markets Index has surged to 16.3% in 2023, compared to 6.4% in 2013, reflecting a substantial jump. The increasing weightage in MSCI indices underscores the confidence of international investors in India’s economic potential and its capacity to generate attractive returns. It also mirrors India’s evolving market dynamics and its pivotal role in the broader landscape of emerging markets. 

China, one of the closest emerging market peers of India, on the other hand, has witnessed consistent reduction in the MSCI Emerging Market index. Its presence in this index has declined from 42.5% in 2013 to 29.5% in 2023, indicating a noteworthy shift in its representation in the global financial landscape. This decline in weightage can be attributed to various factors, regulatory changes and economic uncertainties being the prominent ones. Increased scrutiny and regulatory interventions, particularly in sectors like technology and education, have forced international investors to reassess China’s risk profile. Economic concerns, such as challenges in the property market and debt-related issues, have further impacted market sentiment.

The retirement fund of the U.S. federal government has opted for a benchmark index switch in 2024, transitioning from the MSCI EAFE index to the MSCI ACWI ex-USA and ex-China (Source: Federal Retirement Thrift Investment Board). This strategic adjustment has the potential to initiate a significant reallocation of approximately $28 billion across global stocks. Notably, India stands to benefit from this shift, with the potential for inflows amounting to $3.6 billion, equivalent to over ₹30,000 crore (Source: CNBC TV18).

India’s bond market is poised for significant advancements, with expectations of it being included in JP Morgan’s Government Bond Index-Emerging Markets (GBI-EM) from June 28, 2024. Forecasts suggest that India’s representation within this substantial $213 billion Global Diversified Index will reach its peak at 10% by March 31, 2025. The integration of India into the JP Morgan GBI-EM index carries wide-ranging implications, fostering increased mobilization of funds and further cementing Indian economy’s position into the global financial realm. This strategic move is anticipated to expand the investor base for government securities, effectively addressing the growing borrowing requirements of the country. This initiative is expected to have a positive impact on India’s balance of payments, debt management, and contribute to strengthening of the national currency, the Indian National Rupee. It is noteworthy that India is also being considered for inclusion in FTSE Russell’s Emerging Markets Global Bond Index (Source: FTSE Russell) and Bloomberg Fixed Income Indices (Source: Economic Times). The combined oversight of assets exceeding $5 trillion (Source: JP Morgan) by JP Morgan, FTSE Russell, and Bloomberg Barclays underscores the influence of these developments on the global financial landscape.

Here are the prominent factors contributing to India’s rising dominance within emerging markets:

Increase in household consumption fueled by household debt, which is self-sustaining: The RBI MPC minutes state that the inclination to spend, even at the expense of diminishing savings, holds significant importance. This holds true in particular as household (HH) consumption has played a pivotal role in sustaining the economy amid challenges such as fiscal consolidation, sluggish external demand, and subdued capital investment. There is a possibility that this consumer confidence may evolve into a scenario where strong demand for consumption stimulates economic growth, generates income, and fortifies household balance sheets. However, it would be a stretch to imagine that higher HH consumption (as % GDP) => stronger demand => higher investments => lower consumption and higher savings as a % of GDP – it would obviously be completely circular. Hence investments have to rise, add to growth, and lead to consumption compressing and savings expanding as a % of GDP. China followed exactly this path since in 1991 with a massive investment drive and consumption fell as % GDP as can be seen in the chart below. But per capita Chinese consumption rose from parity to approximately 3.5x of India’s per capita consumption, over three decades, thanks to overall GDP growth acceleration from the investment drive.                 

India’s investment intensity quite comparable to other EMs except China: India’s investment rates at 30% are broadly in the range of other fast-growing emerging economies like Vietnam, and significantly higher than Brazil. South Korea, a country with a significantly higher per capita GDP ($32,418 in 2022) than India ($2,392 in 2022), is an exception with a high investment intensity. However, otherwise, India’s investment intensity is holding up at strong levels. Further, if the Indian economy continues on its path of higher services output, import substitution, and export focus, the savings-investment gap should rebalance favorably.

Narrowing current account deficit: In Q2 FY24, India’s current account deficit contracted to $8.3 billion, approximately 1% of the country’s GDP. This represents a decrease from the Q1 FY24 figure of $9.2 billion, accounting for 1.1% of GDP. A comparative analysis of the first half of FY24 and FY23 reveals a substantial reduction in the current account deficit, nearly halving from $48.8 billion (2.9% of GDP) in H1 FY23 to $17.5 billion in H1 FY24. A reduction in CAD helps keep inflation under control, lends stability to the INR, improves credit ratings, supports external finances, and boosts investor confidence.

India’s ICOR among the best:  India’s Incremental Capital Output Ratio (ICOR) has been amongst the best across major countries over the past two decades. This bodes well for FDI inflows into India in the coming years – while governments in other countries may prop up private sector ICORs through fiscal extensions/subsidies, the corresponding load on India’s fiscal position will be lower relatively, and keep government bond yields relatively benign, thus helping with interest costs indirectly.

Strong corporate earnings across sectors to drive EPS growth: India’s credit multiplier, measuring credit growth against nominal GDP growth, is currently tracking well below its long-term average (LTA), both for total credit and banking system loans. The credit multiplier based on total credit stands at 0.8x compared to the LTA of 1.1x, while the banking system credit multiplier is at 1.0x versus the LTA of 1.3x. Anticipating a rebound, analysts at IIFL Capital Services project the multiplier to reach approximately 1.2x over FY25-26. This positive trend is supported by favorable factors on the supply side, such as improving data availability, exceptional asset quality over the past 15 years, the highest-ever capitalization, and the end of disintermediation from the capital markets. Demand-side factors, including rising consumption-driven loan demand, a shift from unorganized to formal financing, and encouraging signs in capital expenditure, contribute to IIFL’s expectation of a 13-14% loan CAGR over FY25-26. Consequently, analysts at IIFL Capital Services anticipate strong performance from Banks and NBFCs over the next few years. Capital Goods companies too have maintained optimism driven by robust underlying demand from both domestic and export markets. Factors like demand-supply gaps, improved pricing, and confidence in sustaining capital expenditure momentum have prompted capacity expansion, particularly in response to the recent revival in the Power sector. Macroeconomic conditions for Oil Marketing Companies (OMCs) are also turning favorable due to declining oil prices, a rebound in GRMs, and improving margins in the auto-fuel segment. Expecting substantial earnings gains in this positive macro environment, OMCs appear promising. Valuations across PSUs remain attractive, with dividend yields ranging from 5-11% and a moderate 4-7x FY25 estimated Price-to-Earnings ratio even in a normalized operating environment. Among PSUs, OMCs stand out with significant potential for further earnings upgrades. In Q2 FY24, Pharma companies exceeded expectations in EBITDA margins, driven by a reduced intensity of price erosion in the US generic market, stabilized input prices, and disciplined management of operating and promotional expenses for the Indian business. The overall outlook for the pharmaceutical sector remains optimistic for the next 1.5-2 years, driven by diminishing price erosion in the US generic market due to product shortages and disruptions in the supply chain. Diversified EMS players serving B2B portfolios in Industrial, Transportation, and Automotive (EVs) sectors continue to lead growth with robust domestic demand, continuing import substitution, and a gradual increase in qualifications from global OEMs for domestic and global supply chains. Stakeholders in the Power sector too anticipate continued stable demand growth. The industry is hopeful for regulatory stability (generation/transmission/distribution) to encourage fresh investments in thermal generation, aligning with the Ministry of Power’s call for adding 80GW of coal-based capacity. This call enhances growth visibility for incumbent utility companies with strong balance sheets. Thus, the analysis reveals a promising trajectory for India’s economic landscape across various sectors which can help the indices scale new highs in 2024.

Ending this article with an interesting quote from the Oracle of Omaha, Warren Buffet. “I don’t look to jump over 7-foot bars. I look for 1-foot bars that I can step over.”