Indian equities’ post-election rally last year fizzled out quickly. But we believe that lower interest rates—despite a looming US rate hike—may soon unlock their value, offering solace for investors reeling from the recent Chinese sell-off.
Market sentiment changes fast. It wasn’t long ago that the India story seemed as good as it gets: a reform-minded government with an unprecedentedly strong mandate; falling energy prices; lower inflation and an impending economic recovery. Fast forward to early 2015: India was relegated to the backburner. Weaker-than-expected earnings, an attempt to retrospectively tax foreign investors, and tough legislative battles prompted investors to focus elsewhere—particularly as the Chinese market skyrocketed.
The Sensex Index of Indian stocks has risen just 1% this year in local-currency terms through August 18, after surging 30% in 2014, driven by optimism following the election of prime minister Narendra Modi. Still, Indian stocks have outperformed the broader MSCI Emerging Markets Index this year by 8% in US-dollar terms.
Look Again: Earnings Recovery in Sight
It may be time to take another look at the market. The price-value gap has widened for many high quality companies, suggesting a better risk/reward ratio for investors. An earnings recovery is in sight, and we believe lower interest rates hold the key.
Real interest rates are the highest they’ve been in a long time, as inflation has declined more than nominal interest rates have (Display). High real rates are detracting from consumption growth and inhibiting the long-awaited investment recovery. For example, homebuyers no longer enjoy low real mortgage rates and are holding back purchases at the margin. For businesses, rising real interest rates have fueled expectations of lower nominal rates—why invest now when they can borrow at lower rates later? And for industrial companies faced with falling wholesale prices, stubbornly high interest rates have hurt their profitability.
Inflation Under Control
We believe that inflation should remain under control as the decline in commodity prices filters down to retail-level goods and services (Display). Even consumer-staples companies, which typically have strong pricing power, are starting to talk about passing on lower input costs. Food prices, accounting for 40% of the consumer price basket, will also likely be subdued as this year’s monsoon has turned out to be better than expected.
In our view, high policy rates and market rates in real terms reflect the conservatism of investors and the Reserve Bank of India (RBI) in anticipation of the US Federal Reserve’s rate hikes. But we believe that India is much better positioned to weather possible capital outflows today than in 2013, when prospects of a tapering in the Fed’s massive asset purchases shook emerging markets. Look no further than the higher real rates and a rupee that is already 20% cheaper today. These adjustments, together with better governance and improved external accounts, should mean that India will be better prepared when US rates start to rise.
Our conversations with banks and financing companies in India suggest that domestic liquidity conditions are healthy and marginal funding costs continue to fall. Banks are under pressure to further lower their base rates, lest they get increasingly disintermediated by the less costly debt markets readily accessible to highly rated borrowers. On the ground, consumers and businesses both expect inflation and interest rates to moderate.
Big Benefits for Equities
It’s hard to overstate the benefits of lower real interest rates to the economy and the equity market. For example, mortgage lenders will see greater loan demand as the cost of mortgages converges towards the already lowered expectation for home price inflation. Mortgage loans as a percentage of GDP stand below 10%, and lower real rates should help to accelerate their penetration. Credit quality for mortgage lenders should also improve in this environment. Toll road operators will gain from the enhanced feasibility of new projects and faster traffic growth for existing projects due to a rebound in industrial activity. Toll tariff hikes have already moderated as a result of falling wholesale inflation; it’s only a matter of time before project financing costs decline commensurately.
Another beneficiary will be the auto sector, which should see a return of the price-sensitive first-time buyers as lower real rates improve their purchasing power. Generally speaking, we believe that high quality businesses in the financial services, industrial, and consumer durable sectors will be the biggest winners in the months and years ahead.
So despite the prospect of a US rate hike and the Chinese market turmoil—both of which are typically negative for emerging-market equities investment—we believe Indian equities are poised to regain momentum. By looking beyond this year’s controversies, investors can find attractive opportunities in select stocks, particularly in industries that are likely to benefit from lower real interest rates.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.