India’s Economy: Beyond Modi

The Indian equity market was one of the strongest performing markets in the world in 2014, but so far this year, performance hasn’t been as spectacular. While the vision that Prime Minister Modi has for India is positive, expectations have run ahead of execution. So does the investment case for allocating to India’s equity market still hold up?

The equity market rally during 2014 was based less on the improvement of fundamentals and more on sentiment, which was largely driven by a renewed sense of hope for the country. Prime Minister Narendra Modi’s election campaign evoked the belief that reforms could spark change in governance and growth, particularly by improving on executive efficiency and the ease of doing business. Important reforms are also anticipated in the usage of land, labor and other natural resources.

So far, the government has succeeded in making incremental reforms such as improving bureaucratic efficiency and accountability, and it has been able to clear many previously stalled projects that were in need of government approval. But more structural, legislative reforms, such as those that pertain to land, labor and taxation may be more difficult to achieve over the short term. The ruling Bharatiya Janata Party (BJP) has a majority coalition in the Lower House of Parliament but not in the Upper House—and it only has a narrow majority coalition in the combined houses. Some matters require a simple parliamentary majority. But others require a two-thirds parliamentary majority, and/or the additional support of 50% of the states. Currently, the BJP struggles to gain this level of legislative support.

Macroeconomics in India have never been comforting. There has seemingly always been inflation, which has largely remained untamed for the last four decades. In addition, the country has had the problem of twin-deficits. Reforms have also generally lagged expectations. But India remains a country where much can be achieved over the next decade to improve people’s standards of living, spending power and productivity. It is one of the few high-growth regions that investors can get access to via an established equity market. The demographics in India are particularly favorable, and entrepreneurship of the young should be one of the biggest drivers of returns over the long term. And most importantly, the stock market provides a potentially rich set of entrepreneurial opportunities to access this resilient underlying growth without being affected by macroeconomic conditions.

At Matthews Asia, we believe that India will thrive over the long term, regardless of political developments in the short term. Despite the significant barriers to business that the Indian economy poses, the corporate sector is full of entrepreneurial, innovative companies. For all its issues, the Indian economy has been a secular and resilient growth story. And the electoral victory of a proreform government has given some hope that at the very least the country won’t go reverse gear on the reforms front.

The current government may need more time before achieving a majority in the Upper House, and in the meantime, a number of reforms may be left on hold. For now, the ruling party has resorted to promulgating ordinances for certain bills, which passed some measures into law. But these changes may only be temporary, as they will need approval in the next parliamentary session. The incremental benefits of an efficient and accountable bureaucracy could have some impact on accelerating growth.

Whether investors choose to focus on the macro or the micro, the big question now is whether the strong Modi-driven rally has meant they’ve missed the opportunity to invest. After all, at first glance, India appears to be a relatively expensive market. The MSCI India index traded on a price/earnings ratio of 19.83 at the end of May 2015, and a price/book ratio of 3.2. The figure for the MSCI Emerging Markets index was 14.5 and 1.59, respectively. This may seem to give weight to the idea that optimism about the Modi government has pushed up valuations to a point where the performance of the market will be highly dependent on whether they will deliver. As we’ve seen, there is reason to be cautious about whether this will happen, suggesting that the market may be vulnerable to disappointment.

However, India has generally been a relatively expensive market compared to the rest of the emerging universe. This reflects the higher quality of the India corporate sector as a whole. What’s more, in our view, the market is becoming increasingly selective on valuations: good companies have been rewarded with stronger valuations, while weaker ones have been derated.

In our view, successful investing in this market is not about following the political or economic twist and turns—it’s about discovering growing companies across the market cap spectrum that can thrive. For patient, long-term investors, India still represents an attractive investment opportunity.