From Castaway Market to Investor Darling – in a Year
The election of Prime Minister Narendra Modi and the appointment of economist Raghuram Rajan as head of the Reserve Bank of India (RBI) have much to do with India's market transition. We recently debated what’s next. Our main conclusions:
|Modi and Rajan have set in motion an apparent virtuous cycle: increasing business confidence, accelerating economic growth, deficit reduction, receding inflation, a stable currency and inbound investment. Modi is acting as a hands-on CEO. He has revived stalled investment projects, further curbed government spending and initiated many small changes that make it easier to do business.|
|Under Rajan’s watch, inflation is coming down, real interest rates have turned positive and the currency has stabilized. India’s economy is now at an inflection point: We expect GDP growth to accelerate to 7% annually in 2015, 2016 and beyond, driven by implementing half-finished projects.|
|Risks include a re-run of the 2013 bloodbath in emerging markets (EM ) in anticipation (or fear) of a U.S. rate rise. India is in better shape these days, yet the country is still dependent on external funding.|
|We also have yet to see progress on structural reforms and resolving policy ambiguities in the power sector. The next six months are crucial for investor confidence: Markets are anticipating a clear policy road map in the November-February parliamentary session and budget presentation, as well as rate cuts in 2015. Bottom line: Markets need performance above promise.|
Three Key Points
India's GDP growth is accelerating and inflation is receding.
PM Narendra Modi has the mandate for change – but delivery is key.
Stocks have upside while bonds are supported by likely rate cuts.
|Fixed income is supported by a stable rupee and slowing inflation. We expect India will add to its foreign reserves in the next year as the RBI keeps the rupee from appreciating. We see room for a rate cut in in the first half of 2015, as inflation edges toward the RBI's target.|
|Rate cuts are likely capped at 0.5% as the RBI wants protection against another EM downturn, we believe. Currency swaps may start to price in the prospect of rate cuts of 0.25%-0.5% before year end—ahead of any actual rate reductions. A stabilized currency and used-up foreign investor quota on government bonds support local currency credit, but liquidity is in short supply here.|
|Equity valuations are reasonable, earnings momentum looks set to take off and domestic investors are buying. We therefore think the 30-stock BSE Sensex index has material upside in the next three years. Any corrections (a 5%–10% decline is a possibility) are likely to be short-lived, we believe. We like financials, consumer discretionary and small caps, but are lukewarm about staples.|