India’s equity indices have shown resilience and at times defied the pessimism of global markets. The country’s weight has increased in the MSCI Emerging Market index, cutting into the long-standing heavy weight China. Put this in the context of the economy’s growth recovery, and the stock market’s sentiment seems justified.
But even as the argument of decoupling with the world is put to test, India’s gross domestic product (GDP) growth forecast for this year has already been trimmed. The Reserve Bank of India (RBI) expects the economy to grow by 7 percent in FY23, while private forecasts put the growth at lower levels. Does this mean that the capital markets have not caught up with the economic reality of slowing growth?
One smell test is the market capitalisation to nominal GDP ratio, something that ace investor Warren Buffett considers a good indicator of market valuation. According to Buffett, anything above 100 percent would indicate that markets are leaning towards exuberance, and a ratio below 100 would be a bargain hunt.
Taking the estimated FY23 nominal GDP along with the current market capitalisation, the ratio for India comes smack at 100 percent. That would mean the Indian equity market is fairly valued. But this needs to be nuanced.
Not cheap enough
The ratio has increased consistently over the past three years, corresponding to the pandemic-related stimulus given by both the government and the RBI.
The 15-year average market cap to GDP ratio has been 79 percent. Juxtaposed with this, the current 100 percent ratio shows there is little room to make money here.
GDP growth is expected to moderate in the present and the next financial year but a contraction in one variable may be of little consequence if the overall outlook is bright enough to ensure a greater premium. Notwithstanding the paring down of GDP growth expectations, most domestic economic indicators are robust.
India continues to report improvement in its macro-economic data. Healthy credit growth, robust tax collection, improvement in factory output, and healthy PMI (purchase managers’ index) data helped improve sentiments.
"This ratio can increase substantially over the next 3-5 years. Faster growth in corporate profits, a large number of private companies opting to list, and substantial growth in the influx of new investors can promote faster growth of the market cap compared to the GDP, and thereby accelerate the growth of this ratio in the next few years," said G. Chokkalingam, Founder and MD, Equinomics Research and Advisory.
The pipeline of new companies waiting to get listed has increased significantly because of the tremendous growth in the start-up universe. As of September 7, India boasted 107 unicorns with a combined valuation of $340 billion (roughly Rs 3 lakh crore). Plus, there are a bunch of public sector companies, including the Indian Railways, which are yet to be listed. These could come into the market at some point, which could also significantly expand the market.
Further, the re-organisation currently underway in the corporate sector with unorganised and fringe players yielding ground to organised and bigger players will also enhance the profitability of corporate India, which will push up the market-cap steadily.
Friends or equals?
Market valuation holds little meaning unless compared with peers. Compared with China’s sedate 52.8 percent ratio, Indian valuations seem pretty exuberant right now. Even comparing with a beaten down Germany and UK, which stand at 50 percent and 90 percent respectively, India looks expensive.
Against the 183 percent ratio for the US, though, most markets look undervalued. US equity markets have been propped up largely through monetary stimulus in the wake of the pandemic. This explains why the ratio was a massive 233 percent in 2021 as fiscal and monetary stimulus were driving growth and valuations. Since then, things have moved in the opposite direction. Madan Sabnavis, Chief Economist at the Bank of Baroda, explains that this indicator slips when economic prospects are dim. That explains why the ratio has moderated for most major markets in calendar year 2022.
“The Indian market has fared better and gone in a different direction reflecting the stronger fundamentals in relative terms. For us the ratio has still declined because nominal GDP is growing at higher rate due to inflation,” he added
Although analysts are divided on the near-term and medium-term outlook for India’s stock markets because of the significant outperformance compared to other markets this year, the call for a higher allocation to India is gaining credence considering the growth story. Morgan Stanley recently published a note highlighting India’s growth potential in the wake of the government’s push for infrastructure and manufacturing, and sure signs of an investment cycle uptick.
"India’s high valuation should be viewed optimistically as a high price-to-earnings (PE) ratio, a growing number of direct investors, positive future expectations, and extensive industrial activity is likely to make India’s valuation story stronger. The Indian market is also likely to gain from China’s stifled growth due to lowered profitability in businesses and persistent Covid lockdowns," said Dr Esha Khanna, Associate Professor, NMIMS Sarla Anil Modi School of Economics.
Moreover, credit growth is near a decadal high, the government’s production-linked incentives (PLI) are firing up factories across sectors, and consumption demand has shown resilience. Even so, perhaps the biggest downside is the impact of a global slowdown on the domestic economy.
This brings us to the theory of decoupling. Exports have been a key engine of India’s growth over the past few years. Indeed, exports comprise almost a fifth of the GDP growth. With major economies slowing and even slipping into recession, the boost from exports would be limited, perhaps even absent. This downside risk is being noticed increasingly of late.Chokkalingam feels the recent rally will derail if the deterioration in India’s external economic conditions intensifies. There is also the narrowing interest rate gap between the US and India, which is a key trigger for foreign fund outflows. In the long term, large outflows of equity or debt capital by foreign investors, or a massive bull run in global oil prices could spoil the robust outlook for our stock markets, Chokkalingam added.