Finally, a green light ahead

Waiting for a green light. New Delhi scooter stalled in traffic. What promise does the "New" India hold for investors? - Photo: Vijay Verghese

FOLLOWING the resounding Modi-powered BJP victory at the Indian poll, it is an appropriate point to look into the long-term structural case for the Indian stock market. While international investor perceptions about India have often been coloured by the lack of political leadership, a less known fact has been the stellar long-term performance of the Indian stock market, which has ranked amongst the top two to three best performing global stock markets (in dollar terms) over the last 10 years (16% per annum compounded) to 20 years (10% per annum compounded). So given this background, what is the outlook for the Indian economy and stock market going forward? The Morgan Stanley research team, lead by Chetan Ahya and Ridham Desai, provide a helpful framework with which to view the outlook for India.

To summarise the key points: Over the next ten years: economic growth is expected to average 6.75% per annum creating a US$5 trillion economy, supplying 25% of the increase in the global working age population; and a stock market capitalisation of US$4 trillion driven by an aggregate increase in domestic savings allocation to equities of US$230 billion, and a 15% per annum compounded growth rate in corporate profits.

Aditya Rana

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By 2025, India will contribute to 25% of the increase in the global working-age population - an increase in the labour pool of 124m, compared to an increase of 5m in the US and declines of 8m (Japan), 12m (China) and 28m (Europe).

India's trend growth rates have been rising steadily over the last three decades, from 4.6% in the '80s, to 6.1% in the ‘90s and to 7.6% over the last decade. However, growth in 2013 slipped to 4.7%, following the global financial crisis and poor policy choices made by the government.

The recent stagflation-type environment in India has resulted primarily from: 1) an increase in rural wages (17% p.a. since 2008 from a prior pace of 5-8% p.a.), 2) a deterioration in the fiscal deficit (above 7.5% since 2009 from 4.9% in 2008), 3) a decline in public and private investment (from 26.2% in 2008 to 15.9% in 2014), and, 4) a decline in exports, which grew at a pace of 27% p.a. between 2004-2007 but have fallen to15.9% p.a. in 2014.

The weaker economic environment has been reflected in the decline in productivity growth, with the incremental capital ratio rising from an average of 3.5 during 2004-2008 to 6.7 currently.

Going forward, India's trend growth rate is likely to average 6.75% driven by three key factors: favourable demographics, reforms and globalisation.

Improving demographics, as measured by the age dependency ratio (the ratio of the dependent population and the working-age population), has been one of the key factors behind the higher growth potential in India. This has been the case for the rest of Asia as well over the last 50 years, starting with Japan, then the former Tiger economies, followed by China and now India. This factor has driven the rising savings and investment ratios and the long periods of strong GDP growth, and has also been reflected in the rising savings rate in India.

By 2025, India will contribute to 25% of the increase in the global working-age population - an increase in the labour pool of 124m, compared to an increase of 5m in the US and declines of 8m (Japan), 12m (China) and 28m (Europe).

However, an increasing labour pool is not enough to support higher growth - it is important that the skill base is adequate to compete in a global environment. The education trend in India has begun to improve significantly in recent years - with literacy rates having gone up to 73% in 2001 from 52.2% in 1991 and, in particular, the estimated youth literacy improving from 54% in 1981 to 90% in 2011.

With higher enrolment levels in secondary and tertiary education, it is estimated that the turnout of tertiary level graduates could increase from 2.4m in 2004, to 6.5m in 2014 and finally to 12m in 2025 - bringing India's tertiary educated workforce to 122-125m by 2020 (from 50m in 2010). However, a lot more needs to be done in this critical area as the enrolment ratio of 69% (in 2011) compares unfavourably with other Emerging Markets like China (89%) and Brazil (84%).

The challenge for India is how to absorb the additional 64m job-seekers (assuming workforce participation rates and increased secondary and tertiary enrolments) as the 6.75% expected economic growth rate is unlikely to absorb this population. They key here is to increase the employment generated by the non-farm sector, which created 56m jobs by growing at 8.5% over the last decade.

Increasing globalisation has also been a key driver of the Indian growth story, supported by a growing skilled labour pool and the government's liberalisation policies. This has been reflected in a significant rise in trade flows as a percentage of GDP (from 14.9% in 1990 to 24.4% in 2000 and 54% in 2013). Gross capital flows also increased from 5.5% of GDP in 1990 to 8.7% in 2000, peaking at 35.2% in 2008 and then stabilising at the current 25% level. Exports of goods and services have also increased from 12.3% of GDP in 2002 to 25% in 2014, thereby doubling India's share in world exports over the last ten years.

Reforms are critical to convert favourable demographics into higher growth. The first wave of reforms took place in the early 1980s, which resulted in GDP moving from a 3.9% pace in the early '80s to a 5.3% level by the late '80s. The second wave of reforms came about in the early '90s (in response to the balance of payments crisis), but economic shocks to Emerging Markets (and later the developed world) in the late '90s and the following decade meant that the reforms were not able to fully translate into significantly higher growth until around 2005 when the global economy had recovered. However, post the global credit crisis, reforms were stalled and some even reversed, as policy shifted from growth-oriented to redistributive policies.

The six key areas of reforms the government needs to undertake going forward are: 1) managing growth in rural wages in line with productivity, 2) reducing the fiscal deficit through rationalisation of expenditure and tax reforms, 3) improving the business environment through more policy certainty and less regulatory hurdles, 4) implementing transparent allocation of natural resources and clearing supply bottlenecks, 5) focusing on accelerating urbanisation to increase productivity, and, 6) focusing on reversing the decline in infrastructure investment (from 8.4% of GDP in 2011 to 6% in 2014).

India's strong macro outlook implies superior prospects for the stock market. This is likely to be driven by the following four factors:

Increasing profits: An acceleration of GDP growth should translate into higher profits due to the rising corporatisation of the Indian economy. The relative share of profits-to-wages are at a low and should revert - increasing profits at a compounded rate of 14.6% over the next ten years.

Increased liquidity: The secular decline in the share of equities of household savings since the early '80s has lead to significant underweighting of equities, which should begin to be reversed with rising real rates and favourable demographics.

A stock-picker's heaven: Over the last 10 years, India has been the second best stock market performer amongst all the large markets around the world, with a compounded return of 15.8% per annum (in dollars). This has been driven by low volatility of earnings growth and ROE versus other countries, diversified sectoral opportunities and low correlation of stock returns versus the market.

A stock market forecast: High growth does not necessarily translate into high stock returns - for this to happen the starting-point valuations need to be attractive and the corporate sector needs to be efficient in converting high growth into high profits - on both these accounts India has had a good track record and it is expected the Indian stock market will compound at 12%-15% (local currency) over the next decade.

A comprehensive and plausible case for having a core weighting to the Indian stock market in a globally diversified asset portfolio. India is a classic market for contrarian investing - and being highly dependent on foreign portfolio flows (73% of total capital flows compared with 23% for other EMs) it is also a great barometer for the global "risk-on/risk-off" trade. The market therefore has a significantly higher volatility compared to the volatility of corporate earnings when compared to other countries (more than 3x).

As a friend recently quipped, "the time to sell India is when the press only talks about ‘India Shining’ and the time to buy is when you cannot get anyone (local or foreign) to say anything positive on India". On the day of the 2013 low of the stock market, Ratan Tata, the former head of the Tata group said in a widely reported interview that India had "lost the confidence of the world,” and he criticised the government for failing to provide leadership (Economic Times, 28 August, 2013). The stock market went through a dramatic reversal since exactly that day, with the Sensex rising by 28% and, more importantly, the most beaten down sector - heavy industry - leading the other sectors by rising 80%.

Former Rhodes Scholar Aditya Rana has worked 24 years in investment banking, primarily with Morgan Stanley in London, New York, Tokyo and Hong Kong, spending over two decades in Asia. His experience has been in the derivatives area including interest rates, currency and credit, providing advice to a broad variety of Asian institutional clients on hedging, financing and investments. He now spends his time pursuing various interests, which include providing financial advice, financial markets research, yoga, ayurveda and holistic health. He writes a weekly newsletter covering these topics. He has resided in Hong Kong 15 years.

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Robyn Witherspoon (24 June, 2014) – USA

India has always been a promising bet. Let's hope things stay together time around.