Indian equity markets may need to swallow a bitter pill: Sukumar Rajah

There has been much uncertainty surrounding India’s recent reforms and how they may impact the economy and stock market. Some observers have argued that the government’s move to remove cash from circulation to thwart corruption has been a failure. And, some say the implementation of the new Goods and Services Tax (GST) could be more disruptive than expected.

While it is still too early to be certain exactly how these reforms will play out, our belief is that over the longer term, comprehensive reforms should likely overhaul the current system and improve efficiency.

In particular, we will be closely watching the Indian government’s response to a growing number of bad bank loans—so-called “non-performing assets”.

Government authorities and the Reserve Bank of India have begun to take steps to clean up the system and consolidate affected companies. This has proved a challenge for many Indian companies’ immediate earnings and growth prospects. It’s a bitter pill to swallow, but a necessary one, in our view. We think this reform process should prove positive for long-term investors.

Behind the Highs

In our view, the Indian stock market owes its positive performance so far this year to major developments in government reforms and the spending habits of the growing middle class.

Indian equities are currently trading near all-time highs on the back of a stellar run this year, which may lead some investors to worry they could be too richly valued. However, valuations are not too much of a concern for us right now. We think robust growth over the short term could underpin confidence in Indian equities. Additionally, the pockets of overvaluation lie primarily in small- and mid-cap stocks—an area which has a heavy concentration of domestic liquidity.

Local investors have historically underinvested in equities. However, we’ve seen a recent increase in local investors’ appetite for stocks, which has driven the lower end of the market in the small- to mid-cap space. As a result, we think an increase in momentum could be the beginnings of a multi-decade trend.

While Indian equity valuations in general are near all-time highs, the market-cap-to-Indian-gross-domestic-product (GDP) ratio currently sits around the long-term average, which could indicate there is still more upside for stocks and room for growth.

Consumer Discretionary sectors to benefit from rising middle-class population

The changing Indian landscape, particularly its rising middle-class population, provides reason for us to believe specific sectors can continue to be transformed. These include industrials and consumer discretionary, including clothes, entertainment and leisure.

We’ve previously championed the information technology (IT) sector. However, we think room for growth in the IT sector is currently limited and, as a result, we think the outlook for growth could be challenging.

In some ways, we view the pharmaceutical sector in a similar way we view the IT sector. Indian pharmaceutical companies that sought to gain market share in the vast US pharmaceuticals space have found themselves with limited room for expansion. Short-term issues, including manufacturer disputes, have had some detrimental impact on the sector. As a result, we expect longer-term growth to be much lower compared with what we’ve seen over the last 10 years.

Why demographics matter

The growing number of domestic Indian investors has changed the landscape of its equity market. Better information, education and an increasing middle-class population with a growing savings pool have propped up demand for equity investments.

The size of the middle class in India is growing fast. By 2022, India’s middle class could overtake the United States to become the second-largest middle-class market in the world.1 As its size increases, demand for retail, services and leisure activities should also increase and drive these sectors of the market going forwards.

In our view, Indian equities look attractive for a number of reasons, including government reforms, demographics and a growing middle-class population. India’s favourable demographics could create a tailwind and drive demand to specific consumer-driven sectors in the market.

For now, we believe the agenda for the Indian market is to deal with the aftermath of the changes the government has implemented, and wait for earnings growth to accelerate.

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The author is managing director and chief investment officer at Franklin Local Asset Management, Asian Equity. The views expressed are his own