Recent political environment and latest election
For the last 25 years (beginning in 1989), regional parties gained significant influence over the national government often causing paralysis of governance due to conflicting demands of coalition parties. The dysfunction of the national government peaked in the last few years with analysts concluding that "India and China are often considered to be the world's rising economic powers, yet if China's growth has been led by the state, India's growth is often impeded by the state." With crumbling infrastructure, rampant corruption, stalled economic reforms and unacceptably long new-project approval times there are legitimate concerns that India's government is killing its economic miracle. This led to macroeconomic imbalances, pessimism among investors, corporations and the population at large.
Results of the 16th general election in India were announced on May 16, 2014. After 25 years of messy coalition politics, India will now have a stable, single party government. The Bharatiya Janata Party (BJP) won 282 seats, comfortably above the 272 seats needed for a majority. Further, the BJP-led pre-election alliance (National Democratic Alliance, or NDA) won a historic 336 seats (62% of the seats).
Narendra Modi, leader of the new government, has a reputation as a pro-business aggressive leader with the willingness and ability to quickly push through major changes through the complicated, slow moving and corrupt Indian bureaucracy. He got this reputation while he was the Chief Minister (equivalent of Governor in the US) of the Indian state of Gujarat from 2001 to 2014.
This election in India is akin to the historic election of a Shinzo Abe led government in Japan in 2012. The landslide victory by Abe's Liberal Democratic Party is enabling Japan to undertake historic and radical economic policies aimed at jolting the economy out of its two decade slumber. The Japanese Nikkei 225 Index (Nikkei) rose 67% in the 5 months after Abe's election. The Nikkei fell from that high, but is currently still up 53% from the pre-Abe period.
Indian economy - significant economic tailwinds
Economic reforms in India began in earnest in 1991 in reaction to a severe balance of payments crisis. The reform was led by Dr. Manmohan Singh, who at the time was the Minister of Finance in the Congress Party led government. It has continued inconsistently since then. The combination of economic reforms, it's growing and large highly educated and English-speaking workforce and globalization trends helped India become a major exporter of information technology services, which led to its Gross Domestic Product (GDP) growing by 8.3% per annum from 2003 to 2010. However, this growth slowed to 4.7% in 2012, blamed primary on its crumbling infrastructure and regulatory bottlenecks due to a dysfunctional national government.
A 2011 working paper by the International Monetary Fund concluded that while India has been a latecomer relative to advanced Western nations and East Asian economies, it is in the midst of a major demographic transition. That transition started about 40 years ago and will likely last another 30 years. Large cohorts of young adults are poised to add to the working-age population in combination with falling fertility rates. This leads to working age population growing as a percentage of total population. This demographic dividend could add about 2 percentage points per annum to India's per capita GDP growth over the next two decades.
As per a JP Morgan report India has the world's third-largest English-speaking workforce, a sizable part of which is also highly educated. Every year Indian universities produce more than 3.5 million graduates. The Indian Diaspora (people of Indian origin living outside India) has achieved significant success in business and other areas (click here, here and here), indicating that under the right government structure, the population has significant potential for global success.
A recent Ernst and Young report concluded that India's middle class, currently at around 50 million people or 5% of its 1.3 billion population, is expected to grow steadily over the next decade, reaching 200 million by 2020. This will create a rapidly growing and vibrant consumer base for sustained economic growth.
The election result has led to a historic surge in optimism and confidence among local and global investors, corporations and the population at large (see article 1, article 2). This may create a positive feedback loop in the economy by increased capital investment by corporations and spending by consumers, both supported by major economic reform and reallocation of government resources towards badly needed infrastructure projects.
Domestic and foreign investor flows into Indian equity markets
India's individual investors still have room to boost stock holdings, which account for less than 6% of their assets. In Japan, which has Asia's biggest stock market, 8.5% of household assets are invested in equities. That compares with 33% in the US and 16% in the Euro Zone.
Foreign Institutional Investors (FII) have invested more than $17 billion in Indian securities since the BJP announced Narendra Modi as its prime ministerial candidate in September 2013. Now that the uncertainty of the unpredictable election has passed, it is expected that FII money may have another surge.
India has well developed capital markets, with the stock exchange in Mumbai formed in 1875. Significant capital market reforms beginning with the start of major liberalization in 1991, have increased retail and institutional investor confidence in the integrity and reliability of the capital markets in India.
The broad Indian equity market, as represented by the S&P BSE Sensex Index (SENSEX), is trading at an undemanding 15.4x forward price-to-earnings (PE) ratio. Over the last 10 years, it has traded at an average forward PE of 16.3x, with a high of 23.3x and a low of 9.6x (at the bottom of the 2008-09 crises). Small capitalization stocks, as represented by the S&P BSE Small-Cap Index (BSESMCAP), are trading at an 11.7x forward PE ratio. While the SENSEX is trading at both 5 and 10 year highs, the BSESMCAP is trading at a 22% and 37% discount to its 5 and 10 year highs.
Long-term growth in the price of Indian equities is likely to be driven by both expansion of the PE ratio, which is currently below historical averages, and growth in earnings per share.
Bulls argue that over the next 10 years, India's GDP could grow to US$5 trillion (from US$1.9 trillion) and the market capitalization of its publicly traded equities could grow to US$4 trillion (from US$1.2 trillion). Such growth would depend on, among other things, (1) the new government focuses on significant structural reforms and its willing and ability to push them through the legislative branch of government and ensuring proper implementation by the bureaucracy, (2) reigning in inflation (3) managing the fiscal deficit, (4) managing the current account deficit, (5) the global economic environment, and (6) productive investment by the corporate sector and strong labor productivity growth.
All else being equal, a potentially strengthening Indian currency (Rupee) in the short term due to inflow of foreign capital and in the long term due to improving macro economic variables, will be a tailwind for investors purchasing US listed ETFs that invest in Indian listed equities.
The following US listed Exchange Traded Funds (ETFs) provide different ways for investors to get exposure to Indian equities: EGShares India Infrastructure Index Fund (NYSEARCA:INXX) - focused on companies in the infrastructure sector (during this election, the BJP has stated that a key goal is rapid and large projects to improve infrastructure - roads, railway, ports, power infrastructure), WisdomTree India Earnings Fund (NYSEARCA:EPI) - skewed towards smaller capitalization companies, Market Vectors India Small-Cap Index (NYSEARCA:SCIF) - exclusively focused on small capitalization companies, iShares India 50 (NASDAQ:INDY) - exclusively focused on large capitalization companies.
If there is a terrorist strike in India like the 2008 Mumbai attacks, the right-wing BJP government may initiate military strikes on Pakistan. A direct military conflict between two nuclear armed countries will be a severe negative shock to the Indian economy.
The BJP was founded as the political wing of the Rashtria Swayamsevak Sangh (RSS), which started life in 1925 as a right-wing nationalist paramilitary organization. The RSS is said to have drawn inspiration from European right-wing fascist groups during World War II and is said to have participated in anti-minority (Muslim and Christian) violence. Most senior BJP leaders have an RSS background and Narendra Modi, who will lead the new government, has been a member of the RSS since the early 1980s. Muslims and Christians account for 13.4% and 2.3% of the Indian population. If the new government directly or indirectly supports organized oppression of the minorities in India, it may lead to negative socio-economic consequences.
Since the anticipation of a potential election victory by a Narendra Modi led BJP, the Indian equity markets (SENSEX) has risen 20% compared to a 4% rise in a basket of emerging market stocks. During the same period, small capitalization stocks in India have risen 40%. As a result, some of the upside has already been priced into the stocks. Further, the stocks are likely to be very volatile going forward.
While the NDA government has complete control of the lower house of parliament (Lok Sabha), India's federal system means negotiating through the upper house (Rajya Sabha), in which they are a minority, and negotiating with state governments for faster implementation of key policies.
The new government will also have to deal with headwinds from structural economic issues of high inflation, high fiscal deficit and high current account deficit. Further bad monsoon rains can have a severe negative impact on the critical agriculture sector.
Last week's election results in India, which resulted in the first stable, single-party government after 25 years, may have started a long term (10+ year) bull market. Weak governance due to multi-party coalition politics has been the primary cause for India's growth being significantly below potential. Narendra Modi, leader of the new government, has a reputation as a pro-business aggressive leader with the willingness and ability to quickly push through major changes through the complicated, slow moving and corrupt Indian bureaucracy. Once unshackled, the Indian economy can capitalize on significant tailwinds: demographic dividend, large and growing highly educated workforce, large and growing middle class. While there are risks (detailed above), the risk-reward is very attractive.
Disclosure: I am long INXX, EPI, SCIF. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: KL Investment Partners may change or exit its position (buy or sell shares) without updating this article and without informing the Seeking Alpha community.