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Episode 4

Is India’s economy losing momentum?

Published on: November 20, 2019 • Duration: 15 minutes

This week we focus on the short-term headwinds lining up against India’s long-term opportunities for a market that is close to its all-time highs. The market chatter explores whether the weakness in Hong Kong asset prices poses a contagion risk for other global financial markets. And the whisper looks at the potential equity flows around the Aramco IPO.

  • [00:00:03] Sometime in the next decade, India is expected to overtake China as the world's most populous country. And yet India's economy continues to severely lag that if its noisey neighbour. Many people are convinced that India will be a fantastic investment over the next 20 years. But in the short term, it looks like it may be losing a bit of momentum. And that's the big conversation. 

    [00:00:30] In many ways, India has already been a success story. The Indian equity market, the Sensex started in April 1979 at 100. Today it's over 40000. And even if you adjust for the strength of the dollar, that's a pretty impressive return. There's a lot of investors who think that India will continue to be one of the best performing major markets for the next 20 years. But as always, time frame matters. But firstly, why have so many people become excited about India's long term prospects? Part of it is that investors are desperately searching for the next China. But apart from being the world and Asia's two most populous countries, it's not really a fair comparison. China's growth has left India in its slipstream. Having said that, India's outlook started to improve again in 2014 with the election of the populist President Modi, who really kickstarted an ambitious plan for growth, encouraging foreign direct investment and public private partnership deals. There was digitization. There was demonetization of the economy. The whole population received digital identity cards containing biometric and demographic information. And these are called Aadhaar cards. And then in November 2016, Modi banned the use of 500 and 1000 rupee notes. The equity market experienced a severe decline intraday of 6 percent, but recovered into the close. These were really big and sometimes quite shocking changes. There was also a bank recapitalisation to help kickstart a new credit cycle, whilst updating the infrastructure is very much at the core of the physical changes, with a five year plan to build 84000 kilometres of new roads. Then these infrastructure plans are not just for the highways and railroads, but also for the telecommunications networks. 97 percent of the population already have a mobile phone and with 5G infrastructure being rolled out across the whole country. This will help augment the efforts towards digitisation. And then perhaps the really big thing here is the demographic dividend. India is expected to have one point five billion people by 2025 and a middle class of over 500 million. India has more than 50 percent of its population below the age of 25. More than 65 percent below the age of 35. And next year, the average age of the Indian population should be 29 years. And that compares to China at 37 and Japan quite old at 48. Furthermore, India's female participation rate is incredibly low, having only recently bottomed out at around about 25 percent. So there's lots of upside potential there as well. But the demographic dividend may also be a double edged sword because in an era of automation, there's a lot of people that need to find employment and a lack of employment could be a source of future social unrest. So far, India's enjoyed a relatively low official unemployment rate. But can Modi consolidate his power, accelerate his reform policies? At the 2019 election, Modi increased his majority on a record electoral turnout of 67 percent, and the Indian stock market once again pushed to a new all time high, in the immediate aftermath, but it did fade a little bit thereafter. In September, the government announced a surprise fiscal boost, this time cutting the corporate tax rate from 30 percent to 23 percent and backdating that to April the 1st. The Sensex gained 6 percent in a single day when it reopened, one of the largest gains in the last decade. Again, pushing on to another new all time high. But behind this facade of juiced equity markets, other data points are really starting to show that maybe there are signs that the economy is not actually firing on all cylinders. In the old days, India used to worry about inflation and the CPI. The Consumer Price Index has dropped from double digit levels to, at one point, below 2 percent. But now it's bounced and it's bounced back up above 4 percent with the chance that it might break out even more to the upside. And with inflation in a downward trend, interest rates and bond yields were also drifting lower for most of the decade. Indian government bond yields, for instance, the ten-year at 6 percent looks incredibly attractive on the global stage, particularly when you've got Greece ten-year yields at one point five percent, but that's as long as inflation and the exchange rate are under control. On the trade front, both imports and export growth has dropped into negative territory for the first time since 2015 and the global manufacturing slowdown. So clearly India is not immune from these global headwinds. But perhaps more worrying for Modi are the recent declines in private consumption and investment. These are the blue and red bars on this Refinitiv data stream chart. With these in decline and India's GDP growth has struggled to even hit 5 percent, which is the lowest level in five years. When two thirds of GDP was being driven by domestic consumption, that gave India a certain amount of insulation against these global economic headwinds. But if investment and consumption are dropping, some of that protection is lost. If house prices are a sign of growh well, what we're seeing with most of the major cities is convergence towards zero except for that hot spot of high tech in Hyderabad, India's share of world trade has also stagnated. But this really took place before Modi came to power. And there are now a few signs that may be the trajectory is starting to pick up once more. And also, in a world where the US dollar has been generally strengthening against pretty much all global currencies, the Indian rupee has also been under pressure. In fact, the dollar rupee exchange rate is near the all time highs and it looks like it's coiling up for yet another breakout. A move on this chart to the upside denotes dollar strength, rupee weakness. And that's one of the reasons why the MSCI India index and the ETF that are based on it are actually still below the 2018 highs, despite the local equity market having traded at a new all time highs, because of the impact of dollar strength and rupee weakness. So for investors, the long term outlook is still incredibly exciting, even though the equity market is expensive both on a historical and on regional comparisons. Modi's policies have generally been pragmatic and scalable, even when they've been controversial. But India is still a very big and very fragmented country, so the market may now be overdue a bit of a breather with risks that the currency weakness and inflation pick up again creating some investor headwinds in the short term. 

    [00:07:07] There's been a lot of chatter about whether the unrest in Hong Kong and the impact on its economy and risk assets will eventually have a negative impact on other financial markets. Now, this is not a view on the political outlook for Hong Kong, but on whether a move in Hong Kong's asset prices can undermine global risk. Last week, as the violence escalated again in, the senior officer said that the city was on the brink of total breakdown. The local Hang Seng index declined sharply, dropping 2.5 percent on Monday, November 11th. But global markets hardly moved. U.S. markets shook slightly in the overnight futures session, but they were soon back making new all time highs. And some people were left wondering, does it really matter for global risk prices? Well, obviously, in Hong Kong and for the Hong Kong economy, the impact is starting to have quite a bite. As the protests have intensified, so the Hong Kong economy has come under pressure with GDP dramatically declining. Last week's final Q3 GDP figure was confirmed to have fallen two point nine percent year on year. Hong Kong's PMI has dropped well into recession territory. And in fact, some would argue that it's in depression territory with the latest reading coming in at thirty nine point three. Recall fifty is the difference between expansion and contraction. Although they were in contraction territory for some time, the collapse over the last few months has been dramatic. 

    The Hong Kong equity market started to diverge from global markets earlier this year, with particularly notable performance last week when the Hang Seng fell nearly 5 percent while the S&P was in fact up 1 percent. But if history is anything to go by Hong Kong, asset prices should not have too much of a bearing on other global asset prices. Now, that doesn't mean that the political development won't impact the global market. But let's look at that asset price potential in perspective. And we can go back and look at the Asian crisis of 1997 when much of the region was in meltdown. The S&P hardly moved. In fact, the Hang Seng fell 45 percent toward the end of that year and the S&P just continued to grind higher. Today, the Hang Seng equity market has a capitalization of around one point one trillion. So if 50 percent were to be wiped out, then, yes, investors will be nursing some significant losses and they will have to offset those losses by selling assets elsewhere. But the declines in 1997 would themselves have wiped out around 200 billion or so. And yet U.S. markets hardly moved on. Even the U.K. Footsie, which had a reasonable crossover with the likes of HSBC and other stocks, only fell by 11 percent. Now, the following year, the S&P did register a 20 percent decline. But by then, there was also a Russian bond crisis and we had the meltdown of the hedge fund Long-Term Capital Management. Now, arguably, those were some of the knock on effects from the Asia crisis. But in some ways, today's uncertainty is due to the greater interconnectivity of global financial markets. That said, the U.S. economy is still relatively domestically focussed where the consumer accounts for about 70 percent of GDP. And over the last five years, the consumer has accounted for 85 percent of the US GDP growth. And today, Hong Kong itself is now barely three percent of China's GDP, whereas back in 1997, it was probably closer to around about 20 percent of the size of China. But there is always the risk of the ripple effect. Events in Hong Kong could escalate trade tensions between the US and China, and the US has already threatened to weaponize its financial assets. And that would constitute a significant step up from trade tariffs. Hong Kong is also a gateway to the global economy for the Chinese for both inbound and outbound flows. Although foreign exchange volumes in China's currency have already been migrating to Shanghai in London. So whilst eyes are on Hong Kong for the socio political ramifications and retaliations and not really for the impact on Hong Kong's asset prices. Global markets can probably easily endure a 10 to 20 percent drop. All else being equal and Hong Kong assets would actually then look cheap to a foreign investor. The bigger risks to the international investment community are the political responses and not the direction of Hong Kong's asset prices. But with US equity markets at their all time highs and getting overstretched, anything can be a catalyst. But although Hong Kong matters, it's not because of Hong Kong asset markets. It's because of the potential for retaliation. 

    [00:11:53] The world's largest company, the oil titan, Saudi Aramco, is coming to the market with an initial public offering on Saudi Arabia's Taduwal stock exchange. The numbers are pretty large. Even the recently revised estimates put the market capitalization in the one point six to one point seven trillion range. To put that in perspective, the whole of Germany's DAX index is only worth one point one trillion. Aramco is the world's most profitable company, generating a net income of over 111 billion last year. Apple only came in second place with 60 billion. It's the best in class for profit margin thirty one point two percent, compared to eight point three percent for the S&P integrated oil and gas sector. According to Refinitiv analyst Tajinder Dhillon. The dividend yield, however, may be slightly disappointing for investors at around 4.5 percent, below Exxon at 5 percent and Shell at 6 percent. The offer period is expected to run over the next few weeks, ending around the fourth of December 2019 for institutional clients. What's really interesting is going to be the flows as investors have to make way for the new stock in their portfolios. If Aramco are going to sell one point five percent of the company, that's going to raise around about 24 to 26 billion dollars. Some of this will go to cash rich sovereign wealth funds, but benchmark funds are going to have to sell down some of their holdings in order to raise cash so that they can purchase Aramco stock. Now, if we just look at the E.M. space, we can make some basic guesses as to what or who needs to make way for this IPO in 2019. The Saudi Arabia exchange was admitted to the main MSCI emerging market index with a weighting of around 2.5 percent .Funds that are benchmarked to the MSCI Emerging Market Index will need to raise capital by selling all countries across the MSCI index. The bigger markets will see biggest selling, but size doesn't necessarily equate to liquidity. The three largest components of the MSCI E.M. index are China 33 percent, Korea 13 percent and Taiwan at 11 percent. Taiwan and Korea would be more vulnerable than China, even though China has a much larger weighting within the index. In fact, mainland Chinese stocks, the A-Shares, are also expected to increase their weighting in the index in November, increasing the pressure further on Taiwan and Korea. Within the integrated oil and gas space, EM stocks Gazprom, Lukoil and Petrobras have outperformed their developed market peers. So these stocks look vulnerable to not just index changes, but because they now have a competitor for investor capital. Specialist energy portfolios will also have to make similar decisions too. Emerging markets and energy stocks will all now have to compete with Aramco for investor capital. Even though the actual Aramco free float remains quite small. So for these stocks, the investment horizon just got a whole lot harder as this new entrant joins the competition for global capital flows.