Here's Why We're Upgrading India

Emerging market equities as a group have underperformed so far in 2014. The MSCI Emerging Market Index, EM, is down 5.76% year-to-date as of March 21. However, if the Ukraine crisis continues to de-escalate as we expect, currently high global risk premia should decline, reducing one of the headwinds that have been affecting emerging market equities. Confirmation that the global economic recovery continues, with a quickening pace in the US and only a moderate slowdown in China, is likely to be a further positive factor. While we would still avoid buying the broad emerging market, a selective approach of adding some individual emerging market assets to global portfolios appears warranted.

India deserves consideration in this regard. The Indian economy has favorable long term prospects. It is highly competitive in global markets with low unit labor costs, a sizable and rapidly growing middle class and favorable demographics. Long-term economic growth is likely to average 6+% per annum. It could be higher if it were not for the constraint of inadequate infrastructure and the slow progress on needed structural reform.

India's equity market is performing well in the current environment. The MSCI India Index is up 2.3% year-to-date and has good prospects for further outperformance this year. This positive view of India stands in marked contrast to the view widely held opinion last summer that included India among the “Fragile Five” emerging markets most vulnerable to foreign investor outflows, in view of their current account and budget deficits. Indeed, capital outflows surged, and prices in India’s equity market did tumble as the prospect of the US Fed’s tapering raised fears of higher global interest rates. However, the Fed’s unexpected delay of tapering until last December led to a recovery in the Indian market. The iShares MSCI India ETF (INDA.K), is up 5.8% over the past six months, a period during which the performance of the iShares MSCI Emerging Markets ETF (ARCA:EEM), has been -9.43%.

Since last summer, cyclical macro adjustments, in particular a sustained improvement in the trade balance, have reduced India’s external vulnerability, relieving pressure on the current account, increasing foreign exchange reserves, and stabilizing the currency. The rupee is up over 10% from its August low. Economic growth as measured by real GDP likely bottomed in the current quarter and is expected to pick up in the remainder of this year and in 2015, averaging an annual rate of 4.8% over the two years. We consider the new Reserve Bank of India governor, Raghuram Rajan, who took office last September, to be an important positive factor behind this improved outlook. Having a capable central bank governor who is respected by global markets is a valuable asset for any market. He is moving the RBI towards giving more emphasis to the use of the consumer price index to guide monetary policy decisions. The RBI’s inflation worries probably lie behind the unexpected hike in its repurchase (repo) rate on January 28th. While inflation has been a persistent problem for India, inflation pressures appear likely to ease in the coming months. February’s 4.7% rate of wholesale price inflation marks the slowest rate in nine months.

Another factor in the outlook is the upcoming parliamentary elections that begin next month and extend to early May. While the outcome is uncertain, the election could have a positive effect on the progress of structural reforms. Furthermore, the Indian equity market has rallied in the run-up to past elections.

The earnings outlook in India has improved significantly, with an apparent bottoming of the corporate earnings downgrade cycle. Earnings growth is projected to be in the mid-teens both this year and the next. Valuations are near their long-term historical average and look attractive in comparison with those of other Asian markets.

We have moved to an overweight position for India in our International and Global ETF portfolios. We will monitor the upcoming elections closely, since one of the risks for our position would be a political outcome unfavorable to economic reform and growth.

BY Bill Witherell