The recent elections in India and the swearing-in of Prime Minister Narendra Modi, the leader of the Hindu-nationalist, pro-business Bharatiya Janata Party (BJP), have driven positive sentiment among investors in anticipation of a more business-oriented regime. Much of this has been due to the sense of promise in Mr. Modi's reform agenda to target inflation, reduce the fiscal deficit, upgrade the nation's infrastructure, increase privatization and reduce corruption.
We believe that investors considering an equity exposure in India should look beyond the broad market and make targeted investments to access potential growth in certain key areas of the country's economy. Specifically, investors should think about rotating away from defensive sectors such as consumer and healthcare and move towards more economically sensitive and cyclical sectors such as infrastructure. In addition to infrastructure, we would also highlight industrials, capital goods, banks, and small- and mid-cap stocks that are bound to benefit from resurgence in economic growth in India if Mr. Modi's government is able to enact his reform program.
Have Mandate, Will Reform
The BJP now has the strongest electoral mandate in 30 years to try to enact decisive reform in India. The task for the new government will be to promote trade, foreign investment, encourage manufacturing, and develop energy and infrastructure above all.
The specific reforms within Mr. Modi's agenda include:
- Targeting inflation and trying to bring down domestic interest rates to encourage investment
- Reducing the fiscal deficit by decreasing current subsidies for food, fuel and fertilizer
- Upgrading the nation's infrastructure, in particular power and rail
- Privatizing many parts of the Indian economy that are State-owned or State-regulated, including banks and mining operations, with particular emphasis on coal mining
- Reforming current labor laws to promote and encourage new job growth
- Eliminating unnecessary bureaucracy and widespread corruption
This is not dissimilar to the U.K. in 1979, when Margaret Thatcher was elected on a wave of popular sentiment to reform, after the country had suffered from a period of low growth, high inflation and rising unemployment. Her Conservative Party's platform also was one of reform, including freer labor markets and industrial privatization. During her tenure, the inflation rate dropped from a peak of 18% in 1980 to sub-5% by 1992.
Despite the BJP's parliamentary majority, the representative body might nevertheless provide some roadblocks to Mr. Modi's agenda. Although reforms are necessary and a defining part of the electoral mandate, cutting subsidies will be unpopular among affected constituencies who in turn will likely express their resentment at the polls.
It will also be difficult to privatize national assets; many state assets held under government control are often thought to be sacred institutions. As we have seen in other countries such as Mexico, it can be very challenging to privatize state enterprises without public support. The popular reaction that privatization is "giving away the people's assets" could cause protests and bad PR, thereby undermining the possibility of reform.
So it is by no means certain that Mr. Modi will be successful in his program. This will be a multi-year program and an ongoing feature of his administration.
What Does This Mean for Investors?
The Indian stock market, as measured by the MSCI India index is up 12% year-to-date (as of 5/21/2014; past performance does not guarantee future results). We believe the Indian market to be roughly fair valued; it is in line with long-term averages at around 15 times earnings. In general, Indian equities have traded at around 15 times earnings over the past five to 10 years.
In the short term, we believe earnings are likely to be weak. Economic growth is still somewhat depressed and will remain so at least through the balance of this year. We believe, therefore, the market is likely to be news-driven and not earnings-driven. It will likely react to Mr. Modi's ability to appoint a cabinet, get a budget approved and begin to flesh out his reform program.
For investors considering their equity allocations to India, two specific themes we would highlight are infrastructure and small caps. We believe these are among the areas of the Indian economy most poised to benefit from the anticipated reforms.
To target India's infrastructure development, investors might consider the EGShares India Infrastructure Exchange-Traded Fund (ETF) (NYSE: INXX), designed to provide exposure to the anticipated growth in spending on infrastructure. The companies selected for the fund's underlying index may be positioned to benefit since they include, among other industries, construction and engineering, construction materials, independent power producers, metals and mining and wireless telecommunications services.
To access the potential growth in Indian small caps, investors might consider the EGShares India Small Cap ETF (NYSE: SCIN), which consists of companies with a market capitalization between $100 million and $2 billion.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.
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