India’s Virtuous Cycle With A Catalyst

August 24, 2015

This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today's article is by Scott Kubie, chief investment strategist of Omaha, Nebraska-based CLS Investments.

India’s attractiveness as an investment, especially relative to other choices, has grown to the point that it is worthy of a targeted allocation.

India’s stock market is entering a virtuous cycle where policy reforms will lower inflation and make the country friendlier to business. The recent sharp decline in commodity prices has acted as a catalyst by lowering inflationary pressure. The reforms and lower commodity prices will push inflation lower, allowing interest rates to drop—making more projects economically viable.

A better economy will reinforce the benefits of reform, and additional measures will take place, spurring additional economic growth.

The iShares MSCI India ETF (INDA | C-95) matches the investment thesis most directly, because it provides a diversified approach to India’s stock market. The virtuous cycle described above will benefit India broadly, so a diversified ETF like INDA matches the desired exposures.

Opportunities Across India

India’s economy varies widely by region. Some regions have benefited from India’s strength in technology services and autos; other regions are poor and underinvested. Over 400 million Indians live in poverty, and making investments easier is necessary to break the cycle of poverty in many areas.

India is also behind China in moving its population to cities. The potential for India to be the most interesting global growth story is there, but changes are needed.

First Steps

Narendra Modi’s election as prime minister of India was the first step in improving India’s attractiveness. Modi was elected as a pro-reform candidate, whose service as chief minister of Gujarat benefited his constituents by making it easier for corporations to expand and hire. Corruption and bureaucratic resistance have reduced economic growth in India for decades, and slowed millions from joining the middle class.

Modi’s efforts have had mixed success so far politically. But the point that investors often miss is that momentum from political reform is uneven and takes time to affect the economy. The following graph shows the number of investment proposals are helping things turn in the right direction. These investment projects only affect the economy once they start, so the benefits of reforms are just starting to become tangible more than a year after Modi’s election.

The Influence Of China

On its own, the reform cycle is positive for Indian stocks. However, China’s recent decision to depreciate the yuan has made India’s situation look relatively more attractive and lowered expectations for future inflation in India.

India is a major importer of energy, and oil prices have fallen in response to lower expectations for Chinese growth. Inflation has also declined, coming in at 3.78 percent in July, down from 5.40 percent in June and below expectations of 4.46 percent.

China’s slowing economy also creates space for India’s growth to rise in importance. In the previous decade, China’s growth rate outpaced India’s. With China’s decline and India’s improvement, it is likely India’s growth will pass China’s either in 2015 or 2016 (using China’s inflated official numbers).

The decline in inflation makes it a possibility that the Reserve Bank of India will cut rates in the future, further supporting growth.

The virtue of a strong economy makes up India’s trailing P/E ratio of 20x, which is considerably greater than the average emerging market trading at 14x earnings. Historically, India has traded at this premium. Based on higher expected earnings growth, this premium is justified.

Portfolio Application

Emerging markets have been a challenging part of the portfolio to hold in recent years. Concentrating the portfolio in Asia, away from commodity producers, has helped performance.

With China’s economy slowing further, commodity importers are likely to outperform. Within that group, countries that trade a lot with China—like Taiwan and Korea—are more likely to feel the effects. India is much less reliant on China, and its demographics are attractive.

Tilting your emerging market allocation to India has the potential to benefit your portfolio.

At the time of writing, CLS Investments held a position in INDA. CLS Investments is an Omaha, Nebraska-based third-party investment manager and ETF strategist. CLS began to emphasize ETFs in individual investor portfolios in 2002, and is now one of the largest active money managers using exchange-traded funds, with more than $2 billion invested. Contact CLS’ Chief Investment Strategist Scott Kubie at 402-896-7406 or at [email protected]. Please click here for a complete list of relevant disclosures and definitions.

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