Emerging market (EM) equities are still looking good, trade risks or not. A healthy global economy offers support while structural reforms are putting domestic growth on a self-sustaining path in key countries. Case in point: India. A brightening economy is boosting earnings expectations and, we believe, offers a cushion against potential trade-related shocks.
The progress India has made in cutting back costly government subsidies on items such as fuel is a prime example of the advances being made in structural reforms under Prime Minister Narendra Modi. Subsidies as a percentage of gross domestic product (GDP) have declined in recent years, as shown in the chart below.
The government has also taken steps to plug leaks in the system by paying out subsidies directly, via bank accounts, rather than through agents or intermediaries. Measures aimed at increasing financial penetration and bringing swathes of the informal economy into the formal economy are supportive of long-term growth, in our view.
EM reform is not a new theme. But reform momentum has picked up significantly in a few major countries, such as China and India, fostering a more sustainable growth path. EM equities are coming off a stellar 2017, but we see room for more gains as investors flock back after years of EM under-allocation. India – among our favored picks within EM – is a good example of what is on offer.
The Indian government is tackling chronic low productivity, bad loans in the banking system and the bureaucratic barriers hampering the private sector. Social challenges exist – primarily job creation over the coming decades and lifting the rural economy out of its funk. There are no easy fixes, but we see signs of progress after a series of fits and starts. A national tax system for goods and services has replaced an inefficient structure of myriad rates and payments, offering the potential to boost productivity. Financial sector reform is particularly encouraging. A government-led capital injection into banks has helped to repair balance sheets. The clean-up of non-performing loans and banking sector recapitalization are clearing the path for private sector investments and a long-awaited capex recovery. Corporate earnings in India are looking up again, with analysts expecting 2018 earnings growth in the area of 21%.
The IMF sees India as the fastest-growing major economy in the world this year and next. We do not see a significant change in power in next year’s general election, but fiscal restraint could weaken heading into an election year. India’s large rural economy – stuck in a rut for years – appears to be the area of focus. Drawing workers away from low-skilled agricultural employment is critical for long-term success.
We find India is less correlated to the global cycle than most EM peers and its domestic resilience underpins our confidence. The equity market is not cheap at 17.5 times forward earnings. But it remains one of our preferred markets in the emerging world due to its strong growth outlook and relatively low dependence on global trade.