India stocks surge on Modi reforms

India’s $1.6tn stock market broke new ground last week, with the benchmark index hitting an all-time high as confidence builds that the government’s reform agenda will strengthen growth and corporate earnings.

But the stock market’s 14.9 per cent rally since January 1 has divided opinion among fund managers who disagree over whether Indian equities can make further gains.

“The most common question that I am asked by investors is, ‘Have I already missed the boat?’, but the answer is no. The outlook for India over the next few years is particularly positive,” says Kunal Desai, manager of Neptune’s £93m India equity fund.

A quarter of the world’s under-25s live in India, part of a large and expanding middle class of several hundred million citizens with rising incomes who are expected to fuel strong economic growth over the medium term. The government, led by Prime Minister Narendra Modi, is pursuing an ambitious reform programme that is attracting support from international investors.

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India-focused equity funds have attracted net inflows of around $6bn so far this year, compared with the $3.8bn registered over all of 2016, according to EPFR, the data provider.

India ranks as the market most favoured by investment managers running broad emerging market funds, holding an average “overweight” position 2.55 percentage points higher than the country’s weighting in the MSCI benchmark.

So far this year, the MSCI India index has risen 18.3 per cent in US dollar terms, outperforming both China (up 1 per cent) and Brazil (up 6.3 per cent), but lagging behind Russia, which has rallied 28.5 per cent.

Mr Desai notes that Mr Modi’s BJP won the state election of Uttar Pradesh in March by a surprisingly large margin.

“The government now has a reasonably clear runway until the next general election in 2019, which will probably stimulate further reform activity in an effort to drive India’s growth higher.”

As part of its reform agenda, India’s government unexpectedly withdrew 87 per cent of the currency in circulation in November. It abruptly scrapped 500 and 1,000 rupee notes, the two highest denominations, as part of a crackdown on “black money” — cash earned either illegally or earned legally but never declared to tax officials.

This led to the closure of numerous cash-dependent small businesses and thousands of job losses.

However, demonetisation has also encouraged savers to move into financial assets, according to Avinash Vazirani, who runs the £837m India fund for Jupiter, the London-based asset manager.

He highlights a significant increase in bank deposits, record inflows into domestic mutual funds and a rise in life insurance sales this year as evidence of the benefits of the move.

In addition, the government has introduced a universal biometric identity card scheme, known as Aadhaar, that will allow benefits to be paid directly into recipients’ bank accounts

“This should lead to an increase in consumer spending and encourage those on low incomes to join the formal banking system,” says Mr Vazirani.

Last month, India’s parliament approved plans to sweep away the different levies that apply on goods in each state and replace them with a single tax, one of the country’s most important reforms since independence in 1947. Long queues of lorries waiting at state borders to pay tolls or excise duties are common across India but the single tax should lead to a significant fall in logistics costs.

The government also plans to provide more affordable housing via measures such as construction projects aimed at the urban poor, increasing subsidies and extending property loans.

“Giving a boost to housing can essentially raise demand for multiple other industries, ranging from steel to consumer finance,” says Shekhar Sambhshivan, manager of Invesco Perpetual’s $296m India fund.

He believes disruption caused by demonetisation was temporary and points out that the government provided relief for low-income taxpayers and small companies that were hit hardest.

These tax benefits will have a cascading effect that should boost consumer spending, says Mr Sambhshivan.

1. November 8 2016: Prime Minister Narendra Modi announces that 86% of India’s currency by value is no longer legal tender
2. December 30 2016: Deadline for depositing old currency notes
3. February 1 2017: Finance Minister Arun Jaitley’s fourth budget maintains focus on fiscal restraint
4. February 28 2017: India’s statistics office estimates the economy grew 7% in the previous quarter, despite the shock of demonetisation
5. March 11 2017: The ruling BJP seals a decisive election victory in Uttar Pradesh, India’s most populous state
6. Market hits all-time high

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But demonetisation prompted changes in India allocations at GMO, the $77bn Boston-based investment manager. GMO cut the net long India exposure in its $3bn emerging domestic opportunities fund from 20 per cent to around 7.5 per cent by January. Once it became clear that the economy was not reacting badly to demonetisation, GMO raised net long position in the fund to around 17 per cent.

Amit Bhartia, a portfolio manager for GMO’s emerging markets team, says banks are flush with liquidity following demonetisation and interest rates have fallen as a result, encouraging savers to put cash into the stock market.

GMO estimates that equity inflows from domestic investors are running at an annualised rate of $10bn- $12bn.

“Liquidity is playing a key role in driving the stock market higher,” says Mr Bhartia.

But those inflows have helped push up the valuation of India’s stock market, which is trading on a price to earnings multiple of 19.6 times for this year, the highest of any emerging market. “The market is priced for a perfect outcome,” says Mr Bhartia.

Shilan Shah, an analyst at Capital Economics, the consultancy, shares these concerns.

“Valuations are higher than they have been over the past five years, which suggests that the scope for further upside [for equities] is limited,” says Mr Shah.

The MSCI India index has risen 18.3 per cent in US dollar terms so far this year, outperforming the broad MSCI emerging markets benchmark which has increased by 3 per cent

Capital Economics expects India’s stock market to drop back later this year, particularly if the central bank begins to tighten monetary policy.

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Analysts have pencilled in average earnings growth across India’s stock market at 17.5 per cent for 2017, rising to 19.8 per cent for the following year.

High valuations have also prompted some cooling in the enthusiasm for Indian equities among managers running broad emerging market funds, according to Copley Fund Research, the data provider.

Two-thirds of the emerging market funds tracked by Copley now hold an “overweight” opposition in India, down from 85 per cent in May 2015, when the stock market was significantly lower.

Steven Holden, founder of Copley, says valuations for other markets are “more palatable, particularly Russia and Brazil, which have both seen allocation increases among emerging market managers”.

Rajiv Jain, former chief investment officer at Vontobel who left the Swiss asset manager to found GQG Partners in 2016, is an emerging-market veteran who is sceptical about India’s prospects. He believes India’s stock market and currency are overvalued.

“Top down, from a political perspective, it looks good, but I think from a bottom-up, company-wise scenario, it’s not good,” he says.

Mr Bhartia of GMO cautions that investors may be underestimating the political risks facing Mr Modi, as the BJP might have to rely on coalition partners to remain in power after the 2019 general election.“The market has not priced in that risk at all and the election is only two years away. Political risks have not gone away and history has shown that just a few individuals can have a disproportionate impact on economic policy,” he says.

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