Look beyond India’s high stock market valuations for more growth

Global investors have come up with various superlatives about why portfolios should hold a sizeable allocation to Indian assets.

The IMF and World Bank regularly remind us that India remains the world’s fastest growing major economy, a pace that will likely result in the market becoming the world’s third largest economy in the not-too-distant future.

India’s demographics are a second well-cited long-term positive, with a relatively young population helping boost consumption spending and savings (and hence investment). A third argument is about how well India is poised to capture a significant portion of the ongoing realignment of global supply chains, resulting in a rise in manufacturing investment and output.

We don’t disagree with any of these views. Indeed, we have recently argued that India can transition into an upper-middle income economy over the next two decades, a transition that can have a very positive impact on Indian equity markets.

However, what excites us most is the increasing maturity of, and access to, Indian financial markets, which allows global investors to benefit from these long-term trends. Also, a wider range of Indian financial instruments are now available to global investors to hedge against the inevitable ebbs and flows of markets.

We currently favour Indian equities over its Asia (ex-Japan) peers, but we would also look further afield, including opportunities created by the greater access to its bond market and the ability to take more granular views on equities. India’s FX stability in recent years adds to the market’s allure.

Favouring large cap equities

One of the biggest pushbacks against the positive thesis on India is supposedly its high equity market valuations. Is the positive outlook fully priced into equity markets? Valuations are undoubtedly elevated, but we would argue a high return-on-equity provides some justification for the rise, especially since the headline level index valuation remains somewhat below its peak.

Having said that, we prefer large-cap equities over small- and mid-cap equities. Valuations arguably look excessively stretched in pockets of the small- and mid-cap segment. The ability to have a greater exposure to the large-cap segment, which arguably offers a larger margin of safety, is one example of how increasing depth in Indian equity markets can allow investors to be more selective.

A second route to mitigating valuation concerns is to take a sector-based approach. We currently have a relative preference for financial, industrial and consumer staples sectors. Besides their own standalone merits, this approach allows investors to own a combination of pro-cyclical as well as defensive assets.

Don’t overlook bonds

One of the biggest shifts in recent years has been the inclusion of Indian local market bonds in major global bond benchmarks. This is a significant development because institutional investors who are measured against these benchmark indices tend to raise their allocations to the asset class to better align with the benchmarks they are measured against.

We believe local currency bonds remain attractive. Investor flows into the asset class are likely to rise as global investors catch up with the benchmark allocation. Indian local bonds offer an attractive yield that is higher than those offered by other constituents of the Emerging Market local currency bond index.

The bonds can also be a source of attractive income at a time when yields are falling across major currencies with the start of a rate cutting cycle by major central banks.

Looking beyond the tactical argument, though, the nascent access to Indian rupee (INR)-denominated bonds offers investors another route to gain India market exposure. While equities provide exposure to India’s growth - albeit at the cost of equity market volatility - bonds allow investors to build more well-diversified portfolios to navigate market ebbs and flows while still retaining Indian market exposure.

For those with onshore access, a widening range of opportunities in corporate bond markets offer another option with its own unique characteristics.

Of course, INR-denominated bonds only add to the opportunities in fixed income assets already available in the Asia USD bond market, where Indian issuers remain a major constituent.

Stable INR positive for global investors

The currency outlook continues to be key for global investors given this can significantly add or detract from USD-denominated returns. We expect the INR to remain largely stable over the next 6-12 months as significant capital inflows particularly into bond markets help underpin the currency.

While some modest INR weakness is possible over longer horizons (economics textbooks remind us that this persists because of the gap in inflation and real rates between economies), this has not been a headwind to long-term returns.

Since 1992, when Indian equity markets opened to foreign investors, the market has been one of the world’s best-performing major equity markets. Indian equities have delivered about 10% annualized returns in US dollar terms since 1992, after accounting for an annualized currency depreciation of approximately 4% against the USD.

Greater access and maturity

India offers a structural growth story for global investors, in our view. Looking beyond the superlative headlines, we believe the ability to access the market through various financial instruments and asset classes is an exciting opportunity for investors with varying risk tolerance.

Attractive long-term opportunities do not make markets immune to the ‘usual’ cycles and bouts of volatility. A more diversified set of opportunities in India provides investors more options to navigate these ebbs and flows over time within their globally diversified portfolios.