2     / India’s capital markets are maturing 

2.1 So far, India’s booming stock market has been the place to go for foreign investors  

Shares are trading near record valuations. A country with India's demographic structure and above-average growth inevitably attracts the interest of foreign investors, especially if the legal and institutional framework is right. But that alone is not enough. Equities are by far the most important investment vehicle for foreign investors and shareholders expect to see profits. In emerging markets, in particular, it can take time for economic growth to generate profits for listed companies. The chart below shows two important developments: While emerging-market earnings (earnings per share (EPS) calculated at the index level for the past twelve months) have barely budged over the past ten years, those from China have actually declined (despite a doubling in GDP over the same period). India’s profits, on the other hand, have not only outperformed its peers, but they have delivered significant growth in the past three years.

The difference in performance between the two Asian giants has naturally generated a certain momentum of its own: several months of strong outflows of foreign investment funds from China to India. However, in view of China's now record-high valuation discount compared to global markets, this dynamic is likely to have peaked. The sharp divergence in the performance of the two markets has resulted in the MSCI India, with a market capitalization of USD 1.2 trillion, moving closer to that of the MSCI China, at USD 2 trillion, and far ahead of the MSCI Hong Kong, at USD 0.3 trillion.

India’s profits have surged in the past 4 years

^{* 12-months trailing Earning per share (EPS)}

^{Sources: LSEG data and analytics, DWS Investment GmbH as of 2/12/2024}

This means that India's shares are trading at an almost record-high valuation premium to other emerging markets and developed markets. At 22 the price-to-earnings (P/E) ratio ‌^[10] is also close to record historical levels for the country. As the chart below shows, the gap to Asia is particularly striking, but this is also a consequence of China's low valuation, which drags down the overall Asian figure. Valuation therefore does not provide any obvious reason to invest in Indian shares. However, as the major U.S. technology stocks show, valuation alone is a very poor indicator of short- to medium-term price trends. If India’s earnings growth continues to develop at an above-average rate and the government's reform efforts develop greater momentum, India should continue to trade at a premium. 

 With the further opening of the bond markets, discussed in the next section, the country's continued efforts to increase foreign direct investment and India's growing weight in the global economy, interest from foreign investors is likely to increase even further.

India’s shares are trading at a remarkable premium

^{1 Price-to-earnings ratio based on next 12 months earnings estimates}

^{2 India-datastream market index- PE ratio}

^{3 World-datastream market index- PE ratio}

^{4 Asia-datastream market index- PE ratio}

^{Sources: LSEG data and analytics, DWS Investment GmbH as of 2/6/24}

Bloomberg Intelligence sees five strong trends^[11] driving India's stocks, and small caps in particular, which have performed almost twice as well as blue chips over the past four years^[12] 1. the "premiumization" of consumption, which is boosting discretionary demand, 2. Government investment boosting industrial companies and railroads, 3. "Make-in-India" boosting defense stocks, 4. increasing household interest in capital markets which could boost financials, and 5. a surge in services exports. However, as we explain below, we believe some of these themes are already more than sufficiently priced into stock-market sector valuations.

Which sectors are we looking at?

India's stock market is much more diversified than that of most other emerging markets^[13] Financials account for 25% of market capitalization, information technology for 13% and consumer staples for 12%. Although we remain stock pickers at heart, there is also something to be said about individual sectors. 

Financials: Banks are typically seen as a proxy for a country's economic cycle and are therefore highly cyclical. We believe they are attractively valued given India's structural growth potential. We believe the market's concerns that net interest margins could suffer in a falling interest-rate environment and that India's banks have too many unsecured consumer loans on their books are exaggerated, even if the tailwind of recent years is now a thing of the past. However, there is more support in most other segments, such as real-estate loans or corporate loans. For the latter, the cycle is only just beginning.  

Real estate: The prospect of falling interest rates means this structurally interesting sector could benefit twofold, in terms of refinancing and valuations. Stricter regulation of the supply side, even before the Covid crisis, has led to a shakeout, as smaller developers have been squeezed out of the market. We are particularly focused on the large developers now that the supply-side environment has returned to normal after three difficult years, while the need for new housing remains unabated.

Consumer staples: In our opinion, hopes that a growing middle class will buy more and/or higher-quality products (premiumization) are overdone in the stock market. It is true that the middle class may expand in cities but, in rural areas, the positive effect of high economic growth is only being felt by consumers to a limited extent. The strong dependence of the rural population on weather conditions (especially the monsoon), together with high food inflation, have a significant impact on real income, which currently provides little support for higher consumer spending.

IT / outsourcing: The absence of a recession in the U.S. is increasing demand for outsourcing services, which had been rather meager during the past 2-3 years. The former growth trend is now resuming. Shares in this sector are reasonably valued and the operating trends are promising.

Infrastructure: Since the lifting of all Covid restrictions, Prime Minister Modi is pushing ahead with the construction of major infrastructure projects again. However, qualified companies of critical size are rare, and we expect the existing ones to consolidate their market position even further. Against this backdrop we do not yet consider the sector too expensive, even after the price rally.

Discretionary consumption: Here, too, there are beneficiaries of formalization and consolidation, namely in the retail sector. We also find some individual stocks in the automotive sector interesting. Numerous new product variants, especially in the field of electric mobility, are about to enter the market. E-mobility in India has so far mainly been introduced via two-wheelers.

2.2 Solid central bank and bond markets opening up  

Central bank’s reliability helps the rupee 

India's central bank, the Reserve Bank of India (RBI), enjoys a good reputation among global investors and, as an independent institution, acts as a fairly reliable guardian of the currency. The alignment with the policy of the U.S. Federal Reserve (the Fed), which has existed for around two decades, is likely to weaken in the wake of the structural decline in current-account deficits. Monetary policy should therefore increasingly be able to focus on national developments and needs. The RBI has raised the key interest rate (the repo rate) by 250 basis points to 6.5% in this cycle (since May '22); we expect the first slight easing in the second half of 2024.

Central bank rates in U.S. and India and exchange rate

^{Sources: Bloomberg Finance L.P., DWS Investment GmbH as of 2/6/23}

Over the past two decades the Indian rupee has steadily depreciated against the dollar, reflecting, in particular, the country’s higher inflation rate and weaker trade balance compared to many developed countries. However, the extent of the depreciation and the fact it has taken place gradually means it does not pose a major challenge for companies in terms of predictability. We also expect the pace of devaluation to slow due to falling inflation differentials and lower current-account deficits, which are primarily the result of structurally rising service revenues.

Inflation hasn’t hit the target level yet

Compared to many industrialized countries, the rise in inflation, as a result of the covid pandemic and wars, was not so remarkable, especially by Indian standards. Although inflation is trending down again, it is still some way off the 4% target set by the RBI. The core rate fell to 3.9% in January, but headline inflation remained above the 5% mark. In India, food accounts for almost half the average household's consumer spending. Even though the importance of the monsoon in India has diminished over the years, it can still have a strong impact on food inflation. Its impact on growth, however, is now very limited.

India’s inflation is not there yet, but on its way

^{Sources: Bloomberg Finance L.P., DWS Investment GmbH as of 2/13/23}

Structure of India’s debt makes it less susceptible to external shocks

India's public-debt-to-GDP ratio remains high, at 82% in the current financial year (FY), but it has fallen from 89% in FY 2021 and the IMF expects it to fall to 80% by 2028.^[14] Currently India still has the third highest public debt ratio among the major emerging markets (after Brazil and China), but the debt is largely domestically financed, with a significant portion held by local banks and the central bank, reducing the risks at times of stress. India's nominal GDP needs to grow by 10% annually to stabilize public debt at current levels, which is a realistic assumption in our view. India's foreign exchange reserves rose sharply by mid-2023 and the central bank used that cushion to mitigate currency depreciation. Since then, foreign exchange reserves have recovered again.

The bond market is going global

JP Morgan's announcement in September 2023 that it would include India's local-currency government bonds in its flagship bond market index, GBI-EM Global Diversified, has attracted a lot of attention among investors, For India it means there could be a total capital inflow of 30-40 billion dollars, from index-oriented and other foreign investors,^[15]   some of which may already have flown in. Twenty-three government bonds with a nominal value equal to 330 billion dollars, easy for foreign investors to acquire under the FAR (Fully Accessible Route)^[16]program, are eligible for inclusion in the index. This will take place from June 2024, with an increase in the weighting of Indian bonds by 1% of the index per month until India's weighting reaches the upper limit of 10% by the end of March 2025. The foreign-owned share of bonds which are eligible for inclusion in the index currently stands at 2.8% but is expected to rise to up to 10% after inclusion. This has already given the corresponding bonds quite a boost over the past six months, as the chart below shows. In January, Indian government bonds had their best month in five years, with foreign inflows likely to have been a factor.

Whether in hard or in local currency, Indian bonds have performed pretty well lately

^{*JPM India Govt Fully Accessible Route (FAR) total return, in U.S. dollar}

^{** Bloomberg US Treasury Index, total return, in U.S. dollar}

^{*** Bloomberg EM Aggregate Index, total return, in U.S. dollar}

^{**** Bloomberg India Index, total return, in Indian Rupee}

^{Sources: Bloomberg Finance L.P., DWS Investment GmbH as of 2/6/23}

Barclays describes the Indian bond market as one of the largest and most liquid in Asia and among emerging markets.^[17] The market has a volume of around USD 2.5 trillion, of which around half is made up of government bonds and the other half divided roughly equally between local authorities and corporate bonds. The overall market has almost doubled since 2017.^[18] According to Barclays, foreign investors are likely to have accounted for around 30 billion dollars in this market prior to JP Morgan's announcement, including 7-8 billion dollars in government bonds.^[13]

Growing demand from foreign investors reduces bond yields and thus the refinancing costs for the state and companies. Lower capital costs also relieve pressure on the highly valued equity market due to the lower discount rate on future profits and the fact that bonds become less attractive as an alternative investment.

The downside could be higher volatility in the bond market, as it may attract not only long-term but also speculative investors who enter and exit the market more quickly. It remains to be seen how the RBI will deal with this.

Overall, however, a bond market that is opening up to global investors should ultimately have a positive impact on all asset classes in India.

3 / Summary: No way around India

For a long time, India's development into an industrial and service nation has been rather incremental, but in recent years the steps have become bigger and bigger. The foundation has been laid by important reforms by the current government, as well as a pronounced investment offensive, especially to strengthen infrastructure. This should help India make better use of the potential offered by its demographic advantage.

There are other supportive developments: strong growth in services exports, which is also keeping India's trade deficit in check and giving the central bank and government more room to maneuver; the opening of the bond market and the inclusion of government bonds in major indices, which should further boost foreign investor interest; growing skepticism in the West about relying solely on China for some products; and finally, the growth of the technology sector, which is being driven by artificial intelligence (AI) and from which India is benefiting as a well-integrated technology services provider. And because India's large catch-up potential – per capita income is one-fifth of China's – should allow it to generate economic momentum regardless of global economic conditions, there are also attractive diversification benefits for investors in our view.

For investors looking to participate in Indian capital markets, the perfect entry point may be hard to find, but medium- to long-term-oriented investors India's above-average growth in our view.