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Dragon or Peacock

In our 17 years in Asia, we have rarely met an investor from India who was bearish on their own market. To be fair, India has delivered in both outright and relative terms. MSCI India has achieved a compound return of 11% per annum since 2007 compared to 4.9% per annum for MSCI Asia ex Japan. Moreover, the outperformance has (mostly) been driven by superior earnings. India’s compound EPS over the same period was 8.9% per annum compared to 3.3% for Asia ex Japan supported by higher nominal GDP and domestic demand. Of course, valuation has also expanded over the period. The forward-looking risk is disappointment relative to lofty expectations.

Chart 1

As we often note, the price you pay (still) matters for your future return. It usually pays to purchase an asset cheap. The challenge for MSCI India is the valuation. The market trades on 25.5 times current earnings and an 65% premium to the region. In addition, trend nominal GDP, superior domestic demand, and earnings growth is well appreciated. That is also reflected in consensus positioning, beliefs, and flows (for example global allocator demand for MSCI EM ex China). Despite the strong performance of MSCI China from the January low relative flows and risk perceptions still favour India although foreign ownership of India has fallen to an 11 year low. This might reflect strength of the domestic fund industry and some (relative foreign caution ahead of the recent election).

While it looks as though the Modi government will be returned, the equity market is -5% today (at the time of writing) on concerns about the ability for the government to pass key reforms on land and labour. It raises some doubt on the continuity of the policy agenda and macro stability. From a behavioural perspective, the bullish case or what could go right is well appreciated. From a macro standpoint, the left tail risk in India is a renewed deterioration in the external position and or inflation that would put upward pressure on the cost of capital. That could be amplified by a poor Monsoon season (if that happened). While the INR has been relatively stable over the past year, it has rarely been a strong store of value over the medium term (trend depreciation is around 3% p.a. versus the US dollar).

On equities bottom-up, UBS have noted that investors pay a “perception” premium for India. Companies in India with the same sector classification, financial parameters and growth, trade at a 70% plus premium on average to their emerging market peers in China or Brazil. As we noted above, part of the premium is warranted by superior fundamentals. However, India has also re-rated over the past few years. As we have noted in the past, there tends to be a self-reinforcing feedback loop between earnings growth, risk perceptions and valuation multiples. Put differently, investors tend to pay a higher multiple when profits tend higher.

In conclusion, we are not suggesting that the left tail risks are the central case. Rather that there is limited compensation if growth disappointed or if there was a deterioration in the cost of capital. India is an excellent long term growth story. However, that is well appreciated in consensus beliefs, asset allocation flow and in the relative valuation. In contrast, no one can imagine the upside risk for MSCI China. Although the Modi government will likely be returned, the slimmer majority has raised some concern about continuity of the policy agenda and macro stability. To be clear, we are not bearish on the market but the price you pay matters for your future return. The way price has responded to news suggests that a lot of hope in future growth had been priced.

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