MRP first added emerging markets as a long theme in early December 2015. At that time, the change we saw triggering improved performance for the emerging markets asset class was a peaking of the US dollar’s exchange rate; we suggested that a major top was forming for the greenback. The previously surging dollar, we argued, had wreaked havoc abroad, in particular for many emerging markets.
The U.S. dollar has subsequently had ups and downs since then, notably surging to a new high in the weeks following the Trump victory. But, at this point, the buck has fallen back to slightly below where it was when we published the report year-end 2015. Clearly, sideways was a lot better for the emerging market economies than the big negative that existed previously when the dollar was strengthening for several years. It was enough to stimulate a decent rally: The emerging market indices have risen 6% over the past 7 months.
Some clients have asked if there is a single country market we prefer over other EMs. Indeed, there is: India, which we had first added as an emerging market theme on May 19, 2014 based on the election of Narendra Modi– even before we turned bullish on the whole emerging markets asset class. We removed it from our list on November 11, 2016 due to uncertainty caused by Modi’s demonetization plan; we added it back on April 6, 2017 when we became comfortable that it would not derail India’s economic growth. Recent events have brightened the outlook more than ever.
India has great potential, both short-term and long-term. As it happens, my colleague Rob Davis was involved in the marketing of the very first India fund launched back in the day. He has penned some thoughts for us on the story as he sees it, all of which makes sense to me. Here are Rob’s thoughts:
“There’s a powerful thematic investment opportunity unfolding in India. Of all emerging markets, MRP considers India to have the greatest, and most assured upside potential, and further that India as a theme, is only in the second inning of its resurgence.
Three years have passed since Modi became the Prime Minister. Since then, he has encouraged foreign direct investment in the Indian economy, increased spending on infrastructure including a high-profile sanitation campaign, improved bureacratic efficiency, and streamlined regulatory constraints on getting things done.
However, it is the most recent developments that reinforce the belief that India is finally beginning to realize the economic promise that has been present for decades, but been repressed by endemic corruption embodied and aggravated by a largely underground, black cash economy. This impediment, amid a tangle of political, religious, and regional conflicts and policies, hindered the central government’s abilty to implement coherent taxation or monetary policy.
This new focus begins with the radical and highly controversial demonitization plan that Modi launched, with the goal of forcing the underground economy and ill-begotten wealth of politicians and business people out of the shadows. First he gave citizens an opportunity to voluntarily and legally exchange hidden cash, pay the appropriate tax, and start over with a clean slate. Some complied. But, many believed there was little the government would or could do to enforce compliance.
Then, on November 8, 2016, the Prime Minister declared that two of the most heavily used banknotes, representing approximately 88% of the money in circulation, would be deemed immediately invalid and exchangeable only for newly issued banknotes of different denominations. Citizens had to choose between coming forward and declaring their cash holdings, or losing it all. It was as though, overnight, the U.S. declared all $10, $20, and $100 dollar bills to be invalid and unusable for any transaction.
The move was heavily criticized by opposition politicians, economists, and the global media as poorly planned and unfair. What followed were protests, strikes, and law suits over the long lines people had to endure at banks, and the inadequate supply of new notes available for exchange. Some said the move was political suicide, and that the worst hit would be India’s poorest citizens, the very ones that Modi claimed to care about the most. The Sensex fell 6%. In fact, there were serious, poorly anticipated glitches in the implementation of Modi’s plan, which resulted in chaos as people rushed the banks to exchange the now unusable banknotes, for cash to buy food and other basic necessities. Indeed, the poorest citizens were hit the hardest.
But then something incredible happened, that none of the critics expected. The very public they thought would turn against Modi instead rallied behind him for his courageous attempt to level the playing field. In the end, the public did not judge him for the long lines and hardship his plan had put them through. The message that won out was that there was finally someone in charge acting decisively on behalf of the all people, to fight corruption, something they never thought they would see in their lifetime.
The evidence came quickly in the February mid-term elections of the largest state Uttar Pradesh. When the dust settled, Modi’s BJP had won 80% of the 403 seats in the member state assembly, an unprecedented victory eclipsing even that of Indira Ghandi, and handing Modi a stronger mandate. Significantly, with Uttar Pradesh now solidly in the fold, BJP controls a rapidly growing proportion of India’s 29 states and many more votes to support Modi’s agenda — such as the newly approved goods and services tax (GST), the biggest tax reform since independence. In addition, the crackdown on black money has led to a surge in 2016-2017 tax receipts and filers.
A further point to understand about the demonetization plan was how it complemented laws that have limited “Bearer Bond” type ownership of real estate, the place where political bribes were laundered. On its own, this would have been simply a one-time, incremental tax. However, by stopping cold the flow of corrupt capital to real estate, prices will moderate to where they should be, more affordable for all. Same for the costs of doing legitimate business.
A recent conversation with a colleague also noted the significance of Modi’s apparent shift from perception as a militant Hindu nationalist to the center, with a focus now squarely placed on India’s economic well-being for all people.
India’s path to its current much-improved position actually began the year before Modi’s election, marked by MIT-educated Raghuram Rajan’s appointment as Governor of the Reserve Bank of India. Rajan served a 3-year term from September 2013 to September 2016, the year he was named as “Central Bank Governor of the Year” by his peers in the central banking community. A decade earlier he had served as the Chief Economist at the International Monetary Fund. Among Rajan’s notable achievements was the dramatic reduction of retail inflation from 9.8% to 3.78 in July 2015, the lowest since the 1990s. He further gained the market’s confidence by instilling institutional discipline. He established formal processes for setting policies, subsequently limiting the role of politics in managing inflation. Equity markets performed strongly, setting the stage for Modi.
Other notable thoughts/developments:
- Government “tenders” (request for proposals) for government projects are now largely carried out on-line, as opposed to being controlled by local “appointed” agents with hands prominently “out”.
- Recently enacted national tax policy for inter-state commerce, streamlining the ability to operate nationally, plus eliminating state by state confusion and more opportunity for corruption.
- Recently enacted legislation to forgive the debts of 21 million small farmers.
- India is a democracy that undergoes periodic, non-violent, election-driven changes of leadership.
- Much like the U.S., the economy of India is less dependent on exports. Approximately two-thirds of consumption is domestic. Moreover, the balance of services and manufacturing is better than has been the case for China and the Tigers. That’s a good thing in that India doesn’t depend on exports as much as its neighbors.
- There is a large and growing middle class of 500-600 million people with an ethic and hunger for education, many of whom speak English.
- Demographic trends are a significant component that separates India from the other BRICs. India is the world’s second most populous nation, just behind China. At 1.3 billion people, it has about 18% of the world’s population, and is growing that population at 1.2% annually. More than 50% are currently under 25 years old. By 2020, the average age will be 29 years old versus 37 in China, and 48 in Japan. India’s large English-speaking population has already made the nation a major exporter of information technology services, business outsourcing services, and software development, providing the foundation for continued and accelerating growth. The good news about this tremendous population advantage is that, by 2020, India will have a labor force of 900 million people of working age that can contribute to unlocking India’s vast potential. The potential fly-in-the-ointment is that, by 2020, India will have 900 million people of working age who will need jobs to realize that potential. This is hardly lost on Prime Minister Modi who is instituting reforms in the education system and upgrading the training provided to workers.
- It should be noted that when Prime Minister Modi was elected three years ago, his ruling party was a minority in the upper house of Parliament which approves most bills, and there was significant resistance to his agenda. As such, until very recently his initiatives have been substantially limited to administrative and judicial matters. However, that scenario has changed significantly with his rise in popularity, driven by all that has unfolded in his first three years as prime minister. Most notable have been the stunning, mid-term electoral victories that have given his party the votes necessary to advance his agenda. The opportunity now exists for Modi is greater than ever to address substantive issues, such as the engrained ethic of corruption, mob violence, an inefficient power generation and distribution system, ineffective enforcement of intellectual property rights, decades-long civil litigation dockets, inadequate infrastructure, and deficiencies in basic and higher education — is greater than ever. The runway is clear and long, and the journey much closer to the beginning than the end.
- Three years ago, Modi had many detractors. He is now perceived within India to be a leader “of the people”, matching the popularity of Indira Ghandi. As things stand, he will enter the 2019 re-election campaign with a huge advantage. The discussion has turned to whether he will eclipse India’s first Prime Minister Nehru, who was elected three times. However that plays out, there now appears to be an extraordinary opportunity for India, under Modi’s leadership, to realize its enormous potential, as the “real” economy should have a good runway for a few years.”
But, do all of these positive developments add up to a bullish case for Indian equities? Our answer is yes because, in the wake of these transformational changes, the economic and corporate profits growth outlook is better than ever. India as a change-driven thematic investment opportunity now has the potential for continued and accelerating growth. From 1997 to 2011, the economy grew at an annualized rate of 7%. That growth rate was halved in 2012 and 2013 before recovering back to the 7% level over the past two years. While Modi’s bold demonetization plan will have some impact on near-term numbers, Finance Minister, Arun Jaitley, recently said that India will continue to grow at a rate of 7-8%, an “absolute normal” for the country under current global conditions. But some are thinking even bigger. NITI Aayog, India’s policy think tank, has projected that India’s GDP could hit $10 trillion by 2032, from its recent level of $2.1 trillion. That would be a growth rate of 10%.
Meanwhile, we are well aware that the favorable India story is not a secret. Indian stocks enjoy a higher valuation than the other BRICs and the emerging markets overall. Indeed, it is higher than its own long-term averages. But the India growth story is exceptional compared to other developing economies. Also, most of the rise in relative valuation occurred prior to the recent Uttar Pradesh vote. So, it is hard to argue that the transformational change currently underway is already priced in.