India and China are very different economies, so it’s surprising how alike their markets have performed in the past year. Both the MSCI China and the Sensex are down around 18% in 2011, putting them among the world’s worst performing major markets.
For China, that’s not a shock. There’s been no shortage of stories explaining why investors have turned against it in the last few months.
But India’s slump has drawn far less attention. Unless you have money in the market, you probably wouldn’t know it’s had such a tough time. And given that India’s economy is driven more by domestic consumption than international trade, you also might have expected it to be more resilient.
So why has it done so badly – and does 2012 promise to be any better?
Investors in India have been hit twice over
Indian stocks peaked in November last year (see below), with the Sensex briefly going above 21,000. Since then, the only way has been down.
That’s bad enough for local investors. But for foreigners, the situation has been even worse. The rupee has plunged, hitting a record low against the US dollar last month (see chart below). It’s been one of the worst-performing major emerging market currencies in 2011, after the Turkish lira and the South African rand.
So what went wrong? It could be quicker to ask what didn’t.
A year when nothing went right
On the one hand, we have the underlying economy. Inflation has been uncomfortably high in India for almost two years now. Wholesale price inflation now sits at around 10% year-on-year.
This has hurt confidence. And with the Reserve Bank of India (RBI) steadily raising interest rates in an attempt to bring it under control, growth is slowing.
Figures for economic growth in the next couple of quarters could easily be 6.5% year-on-year or lower. That would still be one of the highest rates in the world. But many had hoped that India would soon accelerate to double-digit GDP growth.
At such a precarious time, the last thing you want to see is bad governance. But that’s what Indian investors have been getting. The last year or so has seen a number of high-profile allegations of corruption and other scandals. This included an enormous alleged fraud involving the award of telecoms licences in which the telecoms minister is directly implicated.
This has made the ruling coalition seem incompetent, and has led to political paralysis. The government is fire-fighting crises rather than setting an agenda. There’s a widespread feeling that reforms have stalled as a result, but frankly, the appetite for reform already seemed to have weakened even before these corruption scandals.
These problems have hit sentiment hard, especially among foreign investors. (Indian politics has always been extremely corrupt, but it seems many people hadn’t realised that.) In 2010, foreigners bought $29bn of Indian equities. In 2009, they bought $17bn. But this year, they have been net sellers, selling around $300m. Foreign flows have an extremely large impact on the direction of Indian stocks, so it’s not surprising that the market has struggled without this support.
There are other worries for investors. Private investment has been weaker than hoped, while the government is running a larger-than-expected budget deficit. But these are really symptoms rather than causes.
If the economy was sounder, corporate expenditure would be holding up better and tax revenues would be stronger. In essence, inflation, growth and confidence are the main problems for the market.
No reason to panic about the outlook
India doesn’t sound a particularly solid investment story right now. So is there any good news?
Yes – and more than you might expect. Firstly, some of these problems are cyclical rather than structural. Inflation should probably peak in the early months of next year. After that, the RBI should be able to begin cutting interest rates. That means growth should hit bottom a little later.
And even though India is set for a slowdown, the consequences shouldn’t be as bad as some fear. Bank stocks have taken a beating over fears of borrowers getting into trouble. But while non-performing loans are bound to rise in the next year, the situation is unlikely to be too serious. Indian banks are generally adequately capitalised and able to deal with this.
The Indian economy also remains relatively self-contained and domestically driven, which should limit any damage caused by problems in the eurozone. The country is far from export dependent, and actually runs a small trade deficit.
And while the government needs to improve its finances in the longer term, there are no immediate funding risks. Foreign ownership of Indian government bonds is very low and the banks can be relied upon as buyers of last resort.
Companies have been more dependent on foreign investors buying their debt and equity and are more exposed to a renewed global credit crunch. This risk worried me a lot in 2008-2009, but as it turned out, India got through this with relatively few problems. And given that the risk seem no worse this time around, I’m less concerned. I would still focus on better quality companies with strong balance sheets, but that’s always my preference anyway.
On the policy side, the corruption scandals led to a great deal of public anger and campaigns from high-profile figures such as social activist Anna Hazare led to the introduction of an anti-corruption law. The law – which will bring in an anti-graft watchdog – was originally proposed decades ago, but lobbyists have succeeded in having it delayed many times.
This is likely to be passed in the near future, but it’s unclear whether the ombudsman will have enough power to make a major difference. Nonetheless, the way that these scandals have been exposed and discussed very publicly is encouraging for the prospects of a clean-up in the long run.
Is it time to think about buying?
So what’s the outlook from here? The market is on a price/earnings ratio of around 15. That may not look cheap, but India has often traded on a p/e of 20 or more in recent years. It may not be a bargain, but valuations at this level are not a headwind.
However, it’s hard to see an immediate catalyst for a new bull market. Growth is likely to be weaker in the next few months and earnings could well disappoint. The best prospect for an immediate improvement would be if the government gets back on track, with a strong set of policies and a clear determination to push them through. That could bring quite a rapid change in investors’ attitudes.
This looked quite promising last week, when policymakers announced proposals to open up the retail sector to foreign investment. This may sound like a trivial change, but it’s not – Indian retail remains a significant drag on the economy.
At present, the sector is mainly based around individual family-owned shops, with few organised chains. This leads to weak supply chains, high losses and spoilage and low efficiency. These in turn result in high costs, high prices and a direct contribution to India’s inflation bottleneck. Allowing foreign firms to bring in capital and expertise could transform this situation.
So this reform could have real benefits. Unfortunately, it’s not clear whether the government will have the nerve to push this change through. There is substantial opposition from small shopkeepers, and some members of the coalition are already saying the plans will be delayed, which could well mean shelved altogether.
So while you should keep an eye on wildcards like this, overall I wouldn’t count on the Indian market turning the corner within the next few months.
What about the potential downside? While growth is slowing, I’m not too concerned: the way India came through 2008-2009 has made me more comfortable about its resilience. The great weakness from a stock market point of view is the impact of foreign flows.
Stocks are down 18% this year on weak domestic sentiment and no net foreign investment. So you can imagine what might result if foreign investors began pulling their money out en masse. In fact, you don’t have to imagine it – just look at the chart below. From its 2007 peak, the Sensex went as low as 8,500 – almost 50% down from current levels.
Is this likely to happen this time? Conditions would have to get pretty extreme for that to be repeated. For all the problems the problems in the eurozone is causing I don’t see it turning into the same kind of forced selling that we saw in 2008-2009.
Overall, the odds that we have a chance to buy into India at 8,000 or even 12,000 again seem low. However, I wouldn’t be at all surprised if the market goes lower in the next few months as the slowdown and other worries build.
Still, any weakness means that 2012 is likely to be a good time to drip-feed investments for the long run. In particular, the rupee depreciation that we’ve seen recently makes India more attractive than the drop in the stock market alone suggests, since it’s likely to reverse quite sharply once foreign investor inflows pick up again.
I’ll be taking a look at some specific investment ideas at some point in the next few weeks – however, there are two well-known funds that I usually suggest investigating first.
For an investment trust, consider Aberdeen’s New India Investment Trust (LSE: NII). This is a relatively conservatively managed fund with a focus on good quality companies. It currently trades on a discount to net asset value of about 10%. The annual management fee is 1% and the total expense ratio last year was 1.5%.
For a unit trust/open ended fund, the First State Indian Subcontinent Fund is a solid choice. There’s an initial charge of 4% and an annual management charge of 1.75%, with a total expense ratio of 2.1%. Buying through discount broker Cavendish Online avoids the initial charge and gets the annual fee down to 1.25%.