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India: On the Cusp of a Multi-year Bull Market?

Tuesday, July 25, 2017

Madhav Bhatkuly considers recent milestones for the Indian economy, including the implementation of the Goods and Services Tax bill and the rapid transformation of the financial services sector, and explains why Indian equities could be on the cusp of a multi-year bull market.

By virtue of a combination of favourable demographics, supportive economic fundamentals and pro-business policies, the outlook for corporate profitability in India appears very robust. The country benefits from the world’s youngest population, with around 54% (c. 600 million) below the age of 30. Expectations for GDP growth of above 7% in the coming year is partly attributed to its potential to catch up with its regional rivals.

For example, India’s GDP per capita is just 11% of that of the US, compared to 25% for China. Furthermore, now that inflation has fallen to pre-crisis levels, the central bank has ample room to manoeuvre in terms of cutting interest rates and supporting credit expansion. India is also now beginning to reap the benefits of a more effective administration under the promising leadership of reform-minded Prime Minister Narendra Modi, who is committed to delivering a more business-friendly and growth-oriented economy.

Before we go into the details as to why we believe the outlook to be particularly promising, we should briefly explain the caveat to our bullish thesis, which is that nothing in India ever goes up in a straight line. This can be attributed to the nature of Indian politics, with related news flow ensuring that market volatility remains elevated – especially in a multilingual, multi religious and multi ethnic democracy with a corrupt political system. Consequently, those considering an investment in Indian equities should heed the words of Leo Tolstoy who once quipped: ‘The two most powerful warriors are patience and time’.

Potentially huge implications for GDP

Although we are unable to predict with any accuracy how the Indian stock market will perform in the near term, we can cite some encouraging developments that lead us to believe that we could be on the cusp of a multi-year bull market. The first of these is the recent introduction of a fully-fledged goods and services tax (GST). This has far-reaching implications for internal trade as Indian corporations are currently stymied by the individual state-based taxation system, which is to be replaced by one national tax.

The current multi-state system obliges businesses to pay export tax in one province and import tax in another, when transporting goods across state boundaries. With queues at border crossings also creating transportation delays of as much as four days at some borders, the cross-state movement of goods has become a USD 30 billion cash-bribe industry. Since the only alternative has been to fragment the production base across the country (with manufacturing in each state), this has resulted in diseconomies of scale and multiple duplications of facilities. Although we are likely to see some initial turbulence and short-term disruption relating to inventory management and IT integration, the implications of GST on GDP are potentially huge, with conservative estimates suggesting that it will boost economic expansion by 150 to 200 basis points per annum.

A wall of savings

The potential growth relating to the rapid transformation of the financial services sector, which the portfolio currently has around 40% exposure to, is something else that we are excited about. The catalyst for this has been an unintended consequence of last autumn’s demonetisation, which resulted in 86% of the currency coming out of circulation. India was unprepared for the cash shortfall that was created and Modi’s narrative kept shifting at this time. With only 2.5% of the population paying tax and the vast majority not holding a bank account, India is one of the most ‘underbanked’ economies of the world. Modi effectively enforced citizens to open zero-balance bank accounts – as that was the only way they could get rid of their “demonetised’ currency. Cash withdrawals from these were permitted only if the accounts were know-your-customer (KYC) compliant by a digital ID - authenticated by ten finger prints and two iris scans.

As a consequence, India shifted from one of the data-poorest countries in the world to the richest in a matter of weeks, with 99% (excluding legal minors) of the population now having a digital ID and the bio-authentication estimated to be around 98.7% accurate- among the highest in the world. The by-product of this rapid shift is that it now takes a matter of a very few minutes to open a bank account (it used to take four or five days) and customer acquisition costs for financial services providers have fallen by 98% - because India now has digital KYC.

A further implication of the rapid advancements in banking is being felt in terms of ownership of financial assets. India was formerly the biggest buyer of gold with unaccounted money. However, two months after demonetisation, a deposit surge of 35% resulted in substantial flows into domestic mutual funds and the insurance market. The dynamics of domestic equity ownership have fluctuated massively in the last 25 years. In 2007, the average exposure of the average household Indian balance sheet to equities was 9%, but this slumped to 0.9% post crisis and has subsequently recovered to 4.7%.

Between 1992 (when the average domestic balance sheet held 26% exposure to Indian equities) and 2015, foreign flows dominated the local market at the incremental level but post 2016 and the local flows into domestic mutual funds this is all set to change. By our estimates, 10 years down the line there is likely to be a wall of savings ready to be allocated to equities and this assumes that household balance sheet exposure, the savings rate and GDP all remain constant at current levels – we anticipate all three will rise appreciably.

Multi-fold expansion from a low base

Consequently, our high conviction in financial services is based on the vibrancy of the local market as increases in savings and deposits create a surge in product proliferation. Meanwhile, the influence of the digital ID programme has led to a reduction in costs, speedier customer conversion and improving analytics, which, in turn, catalyse a reduction in loan delinquency and a rising growth rate. By virtue of a massive surge in the customer base and the opportunities that digitalisation conjures up in terms of micro financing, there is ample scope for financial services companies to expand multi-fold from an extremely low base.

Furthermore, the outlook for equities needs to be considered in the context of favourable demographics, a likely strong fillip to GDP from GST and a secular increase in local capital flows, which, in turn, is likely to catalyse higher levels of foreign participation in Indian equities. We could indeed be on the cusp of a multi-year bull market.

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The information in this document is given for information purposes only and does not qualify as investment advice. Opinions and assessments contained in this document may change and reflect the point of view of GAM in the current economic environment. No liability shall be accepted for the accuracy and completeness of the information. Past performance is no indicator for the current or future development.
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