Will India be the breakout emerging market this decade?

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Today’s Publisher’s Parmesan talks about India’s potential to be the breakout emerging market this decade.

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Will India be the breakout emerging market this decade?

Is it India's turn to shine this decade? The Indian market has surprised both optimists and pessimists with its performance.

India's rising global influence was evident during Prime Minister Narendra Modi's recent visit to the United States. He addressed Congress, met influential business leaders, and had dinner at the White House. While back home, the country has shown positive signs as well — Corporations are confident, the economy is growing steadily, and technological innovations are driving new areas of growth.

Despite its large size as a democracy, India has enjoyed relative political stability over the past decade, allowing a focus on economic development. While there may be increased political instability and market volatility leading up to next year's general elections, we believe that India is well-positioned for sustained growth. This growth will be fueled by substantial investments in direct and fixed assets.

Here are some key factors that make India an attractive destination compared to other emerging markets.

1. Reforms have set the stage for growth

Since Prime Minister Narendra Modi assumed office in 2014, his administration has introduced pro-business reforms that have accelerated growth. These reforms have made it easier for businesses to access credit and have brought a significant portion of the economy into the formal sector.

• Aadhaar program, a voluntary biometric identification system similar to the social security number in the U.S., has successfully incorporated over a billion people into a national database. By leveraging Aadhaar and establishing credit rating agencies, consumer lending has received a boost.

• In 2017, India implemented a national goods and services tax (GST), replacing a complex web of state taxes. This digitalized system not only streamlines tax collection but also enables the tracking of goods and services at every stage of the supply chain. As a result, the manufacturing and industrial sectors have become part of the formal economy.

• Additionally, the Unified Payments Interface (UPI) was launched in 2016, revolutionizing the payment landscape by creating an instant real-time payment system. UPI allows both banks and non-banking entities to facilitate electronic transactions and offer credit services.

These reforms have brought about a revolution in credit underwriting and have accelerated the lending process.

In addition, there are production-linked incentive programs in place that aim to enhance India's domestic manufacturing sector. These programs are gaining momentum and contributing to the country's economic growth.

According to the International Monetary Fund, India is projected to become the world's third-largest economy by 2027, trailing behind only the United States and China.

2. The infrastructure boom is real

The lack of infrastructure has been a significant obstacle in unlocking India's full growth potential. However, over the past five years, the government has made substantial investments in the development of roads, railroads, airports, and seaports. And as one sees around, it becomes evident that infrastructure construction and the availability of more affordable housing are finally making progress.

An example of this improvement is a car journey from Surat to Mumbai, covering a distance of 170 miles. Previously, this trip would have taken 10-12 hours, but now, thanks to the construction of six-lane highways, it can be completed in just six hours. Along the way, you will encounter several quality food establishments, which is a remarkable change compared to a decade ago.

In Mumbai, the city skyline has undergone a remarkable transformation in the past 15 years. Numerous buildings with 50 or more floors now grace the skyline, and a subway system is being constructed. The residential housing sector is experiencing rapid expansion as well. One notable example is the town of Palava, located 20 miles from Mumbai's central business district. It is a master-planned community that resembles what we used to see in China. In just 15 years, Palava has evolved from a concept to a thriving city with a population of 120,000 residents.

3. Tailwinds for manufacturing are getting stronger

The Indian government's strategy has two main components: increasing its capacity to cater to the domestic population and gradually expanding its presence in export markets. A key objective is to develop a robust supply chain ecosystem, considering that a wide range of product components are currently imported.

Manufacturing capacity is being expanded in sectors such as mobile phones, home appliances, computers, and telecommunications equipment. Prime Minister Modi's administration has actively pursued investments from Japanese, Taiwanese, and U.S. companies to establish new production capabilities. Notably, Apple has begun manufacturing its iPhone 14 line in India, and Japanese companies Daikin and Mitsubishi Electric are planning investments to produce air conditioners and related parts.

Local Indian companies are also making substantial investments to scale up their businesses and capitalize on the rapidly growing domestic market. Leading manufacturers like Amber (air conditioners), Dixon (electronics), and Havells (electrical equipment) are examples of this trend.

In general, the manufacturing landscape is becoming more favorable. Government approvals for land acquisition have become less burdensome, labor costs are affordable, and industrial parks are being developed with dedicated power sources to address historical challenges of consistent power availability.

India is expected to become an attractive destination for companies seeking to diversify their supply chains beyond China, often referred to as the "China plus one" strategy. However, it will likely take several years before India can compete with China as a global manufacturing powerhouse. Nonetheless, the potential for growth and opportunities in India's manufacturing sector are promising.

4. India's equity market has been growing and should evolve

Within the MSCI Emerging Markets Index, India holds a 14% share of the composite index, ranking behind China at 29% and Taiwan at 16%. This indicates that India presents significant investment opportunities, particularly in the small-cap space, considering its positive economic trajectory.

Although the equity market in India is still relatively small compared to the size of the economy, it has substantial growth potential. As of May 31, 2023, the market capitalization of the MSCI India Index was nearly $1 trillion. Notably, smaller companies with market values ranging from $1 billion to $10 billion accounted for almost half of the index.

India's capital markets have experienced a surge in initial public offerings (IPOs) in recent years, reflecting the ongoing transformation of the country. These IPOs include companies in online platforms such as Paytm (payments), Zomato (food delivery services), and Policybazaar (insurance quote aggregator). Venture capital investments have also been pouring into the country. As of December 2022, India ranked third globally in terms of the number of unicorns (unlisted companies valued at $1 billion), behind only the United States and China.

5. Investment opportunities span real estate, financials and industrials

Real Estate: India, projected to become the world's most populous country this year, faces a significant housing shortage. As per the U.N., India is massively under-housed, and housing is expected to play a crucial role in driving and benefiting from the country's economic growth. The real estate sector is projected to contribute nearly 15% to India's gross domestic product (GDP) by the fiscal year 2031, up from the current 7%. This growth will likely drive demand for building materials, cables, refrigerators, and air conditioners.

The real estate sector in India is undergoing a significant structural transformation, which is expected to increase profitability. Government policies have targeted corrupt practices and focused on building consumer trust in the homebuying process. Additionally, a liquidity crisis in recent years led to the downfall of many smaller developers. Consequently, the once highly fragmented market has become more organized and consolidated.

This shift presents opportunities for larger regional developers to capture a larger market share, particularly in constructing homes and apartments for first-time buyers.

Banks: The overall outlook for banks in India appears positive. Loan growth remains strong in both the retail and corporate sectors and the credit environment is favorable. The economy's trajectory, coupled with the consolidation of weaker state-owned banks in recent years, suggests a favorable cycle for banks.

Valuations for the largest private sector banks also seem reasonable compared to historical levels. For instance, HDFC Bank is currently trading at 18 times earnings for the next 12 months, below its five-year average of 21 times. Similarly, Kotak Mahindra Bank is trading at 29 times earnings compared to its five-year average of 40 times, based on FactSet data as of June 23.

There have been concerns in the market regarding net interest margins (NIMs), a crucial measure of profitability, as it is expected that benchmark interest rates will be lowered by monetary authorities. However, the potential positive impact of lower rates on the economy should not be overlooked. We believe that the expansion of credit and robust economic growth provide sufficient potential for loan growth to offset any margin compression.

Mobile communication: The telecommunications market in India has undergone consolidation, with Reliance Industries and Bharti Airtel emerging as the dominant players. We expect the usage of smartphones and data to continue increasing, particularly with the rollout of 5G and fiber-to-the-home technologies in more cities.

Reliance Industries, in particular, has experienced rapid growth, highlighting India's digital revolution. Since the launch of its Jio telecom service in 2016, Reliance has amassed a subscriber base of 439 million and currently handles 60% of the broadband data traffic in the country. India ranks as the world's second-largest telecom market by subscribers, making it an attractive market for global technology giants.

In 2022, Google made a significant investment of $1 billion in Airtel with the aim of making smartphones more affordable. This demonstrates the interest of global technology companies in leveraging the growth potential of India's telecom market.

6. China plus one: The chemicals industry sets a good example

The chemicals industry in India is attracting attention as both governments and multinational companies look to diversify their manufacturing beyond China. Over the past decade, many chemical companies have emerged as the Western world sought alternative sources for specialty and generic chemicals.

India's competitive advantage lies in its large pool of trained scientists and chemical engineers, which has allowed the country to establish expertise in both specialty and commoditized chemicals. This includes chemicals used in semiconductors, electric vehicle batteries, and solar panels, where additional capacity is being developed.

It's important to note that India's chemicals industry is still smaller compared to China, which is the world's largest producer. However, even if India were to capture just 10% of the demand currently sourced from China, it would have a significant impact.

7. The energy transition could be transformational

Indian corporations are actively striving to compete with China across the entire value chain of clean energy, with a particular focus on green hydrogen. Companies such as Reliance Industries, Larsen & Toubro, and Tata Power are among those looking to capitalize on this endeavour, as indicated by conversations with government and industry sources.

The energy transition holds immense potential for transformation in India. If executed effectively, it can yield significant benefits. As a large importer of oil and gas, increased adoption of renewable power would enhance India's energy independence. Additionally, it would greatly bolster the country's manufacturing base.

India's ambitions in the clean energy sector are still in the early stages. Key priorities include building a renewable supply chain from the ground up, establishing global cost competitiveness, driving policy advancements, and attracting substantial capital investments. While achieving these objectives will require time and concerted efforts, both the government and the private sector exhibit a strong motivation to drive progress in this area.

8. Demographics are the biggest advantage

While India is likely to benefit from Western countries exploring China-plus sourcing strategies, the majority of its economic growth will come from domestic consumption and investment. With a median age of 29 years, India possesses one of the most attractive demographic profiles among the world's largest economies. It has the potential to leverage its productive capacity to reap benefits, provided that the right policies are implemented.

Technological innovation, coupled with an improving regulatory and legal framework, has already set India's economy on a path of 5% to 6% annualized growth, which is among the fastest among major economies worldwide. However, with a general election scheduled for 2024, there is an increase in political risk. The prevailing market consensus suggests that the pro-business Modi government will likely retain power, albeit possibly with a reduced majority in parliament.

In the event of a change in political leadership, market volatility is expected to rise. However, all political parties across the ideological spectrum recognize the imperative of achieving economic growth and creating jobs. Therefore, the commitment to these objectives remains strong, ensuring a continued focus on fostering economic growth, regardless of potential political transitions.

9. Valuations are stretched but not insurmountable

When considering investments in emerging markets, it is worth noting that historically, India has traded at a premium on a relative price-to-earnings basis. Presently, the market may appear slightly expensive compared to historical standards, with the MSCI India Index trading at 20 times forward earnings, exceeding its 10-year average of 18 times.

However, despite the higher valuation, we believe that the fundamental outlook for India is stronger than ever. Several factors contribute to this positive outlook: India is one of the world's fastest-growing economies, inflation is well-controlled, the government has shown fiscal responsibility, and corruption has decreased compared to a decade ago. If Indian companies can deliver on earnings and cash flows, there is a possibility that the market can grow into these valuations.

It's important to acknowledge that the path of India's equities has not been a linear one, and short-term fluctuations can occur. However, over longer periods, the stock market has demonstrated some of the best returns among both emerging and developed markets.

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