Ahead of India’s recent election, investors had anticipated a victory for Prime Minister Narendra Modi and his Bharatiya Janata Party (BJP). However, the outcome appears to have surpassed even the highest of expectations, with the BJP alone winning more than half of the total seats, becoming the largest single party majority in 30 years.
In the days following the election, The Economist featured the prime minister on its cover with the words “How Modi can unleash India,” and Indian stocks rallied as market watchers betted that the Modi administration will be able to push forward with its reform agenda.
Now, with the MSCI India Index, a proxy for Indian stocks, up 15% year-to-date (vs. the broader emerging market (EM)’s meager 2% gain, as measured by the MSCI Emerging Market Index), many investors are wondering whether now is a good time to ride the “Modi wave” by maintaining, and even increasing, exposure to Indian stocks.
My take: The answer largely depends on valuations, investor expectations of reforms and how soon the government will deliver.
Valuations. Based on valuation metrics, Indian equities are now trading at a significant premium to stocks in other EM countries. Currently, India is priced at 14.8 times 12-month forward earnings, while the broader EM is priced at 10.8x. On a price-to-book (P/B) basis, while the Indian market’s P/B ratio (2.7x) is broadly in line with its historical average, it nonetheless represents an almost 100% premium over China’s ratio (1.39x) and about an 80% premium over the broader EM ratio (1.5x).
Investor expectations. As indicated by the market’s strong performance leading up to the election and immediately following the results, expectations are exceptionally high that the incoming government will achieve key reforms. While the government’s reform mandate clearly supports investor sentiment and should usher in stronger capital flows, it also means that the government now has no excuse but to deliver on what it has promised, including tackling unemployment, spurring growth, and taming inflation, as well as reining in twin deficits.
The government’s ability to deliver reform. From an economic perspective, it’s important to recognize what an election can and cannot do. The business cycle, i.e. that economies will go through periods of expansion and recession, is a given in any economy irrespective of the government in power. India’s current economic reality is that both fiscal and monetary policies are still tightening, and corporate and bank balance sheets are weak as a result of past policy mistakes. While the Modi victory does impact the country’s investment outlook via improving business confidence and the likelihood of resuming stalled infrastructure projects, nothing moves easily in a decentralized large economy like India (note that government’s current majority only controls 8 out of 29 states). In addition, the BJP still faces a number of key challenges, including restoring fiscal health, achieving a more sustainable current account balance, recapitalizing local banks, and rebuilding the country’s forex reserve. As of yet, none of them is an easy fix.
In short, Indian stocks look relatively expensive and despite investor expectations, it’s too soon to tell whether the government will be able to deliver on promised reforms, which have yet to be executed. Even more importantly, a majority market-friendly government is no guarantee of post-election stock outperformance. The latter depends on the speed of policy delivery and other external factors, and already Indian stocks appear to be giving up some of their election-related gains.
As such, I’m advocating that investors stick with a benchmark weight to India. While there are reasons for optimism, current valuations seem to already reflect a lot of good news.
Sources: BlackRock, Bloomberg, I/B/E/S
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