India: Modi builds support ahead of 2019 elections

Now that some time has passed since the start of 2018 and with it the plethora of strategy pieces, we feel it is now appropriate to communicate our thoughts over this key period for India. We remain convinced that India remains one of the most compelling investment destinations for a long-term investor in emerging markets or indeed globally.

It will be a busy year politically, with a number of state elections that should indicate the mood of the country as we head to the national election in 2019. These state elections will inevitably be influenced by India’s macro backdrop which has witnessed a series of policy moves over the last couple years that have delayed a full-scale economic recovery in the short-term, albeit to the benefit to the country over any other timeframe.

These policy moves have also disrupted the earnings of Indian corporates but the good news from the latest recently finished quarterly earnings season is the emergence of green shoots of recovery in certain key sectors. We believe Indian equity markets are entering a period where they are likely to be more influenced by top-down macro factors than we have seen for some time.

The macro outlook

While the global economy is in the early stages of a cyclical upturn, at a headline level India’s macro outlook remains mixed. Concerns have centred on rising inflation and its impact on central bank policy, whose commentary has become noticeably more hawkish. In addition the fiscal deficit has increased and the trade balance deteriorated. All these factors combined have pushed up government bond yields, also influenced by global trends, and hence India’s cost of capital.

We wouldn’t panic just yet. The fact is that India’s economy is recovering from the twin shocks of demonetisation and the Goods and Services Tax (GST) implementation and is showing further growth momentum in the latest data, evident from most high frequency indicators being positive and the recovery in credit growth. For example companies in the capital goods and construction space recently announced a 62% pickup in new orders for Q3 FY2018, with the best yet to come. Indeed Deepak Parekh, the prominent chairman of one of India’s leading financial institutions HDFC, said at an investor summit on 19 February:

“The worst is over. We had major transformative reforms. Any economy will suffer when you have GST, demonetisation, real estate regulations or IBC[i]. Such reforms do create short term pains but in medium-to-long term there will be gains. I am very bullish and optimistic now”.

A host of macro data out at the end of February also surprised positively. Gross domestic product (GDP) expanded 7.2% between October and December, the fastest in five quarters and better than market expectations of 7%. The government also estimates GDP will grow 6.6% in the year to March 2018, again slightly better than predicted. Momentum is undoubtedly firming even if base effect overstates the apparent pace of headline momentum. Despite a strong global economy, export growth slowed from the previous quarter while import growth accelerated. Consequently, net exports shaved off 140bps from headline growth in Q4 2017, so the recovery was based on firming domestic demand.

We also think that concerns over the rise in inflation are being overplayed. The fact is fundamentals do not justify a fully-fledged inflation scare, with growth remaining well below potential and surplus capacity in the economy constraining pricing power. Most of the recent rise in inflation has come from food price inflation, whose effects are seasonal in nature and we read that a La Niña weather pattern is likely which should further dampen prices later in the year due to a good monsoon and hence good harvests.

There is no doubt that the teething issues following the roll-out of the GST regime are gradually normalising. Introducing the most ground-breaking reform that India’s tax system has seen in decades was always bound to be risky in such a complex country as India. The government has now started the process of simplifying GST to improve compliance and making it much easier to input returns. GST will ultimately generate considerable productivity gains for India, and improve the country’s potential growth rate. It was interesting to see Finance Minister, Arun Jaitley, said on 27 February 2018 that 7-8% GDP growth should be considered normal for India, but it has the potential to grow above 8%. While we would normally take most forecasts by politicians with deep scepticism, in this case we agree.

One other crucial headwind keeping the economy below its potential has been the ongoing non-performing loan (NPL) issues afflicting Indian banks, but particularly public-sector banks. In our October note we discussed these issues and the government’s response – a massive recapitalisation plan. This move we welcomed as a significant step-forward in resolving the issue. It was interesting to see at the recent 11th Mint annual banking conclave in Mumbai, Chanda Kochhar (CEO, ICICI Bank) said the following:

“I think the rate of addition to non-performing assets (NPAs) has definitely slowed down. My firm belief is that NPA is not just about recognition; we should talk about recognition, we should talk about resolution, we should talk about recovery. As of now, the focus in on resolution and that is the good news.”

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The budget

At the beginning of February Arun Jaitley presented his annual budget. On the whole these sort of events are becoming less relevant to markets and this one didn’t particularly disappoint or amaze. Worries over fiscal profligacy were overdone and the government announced the introduction of a long-term capital gains tax of 10% which was also expected. There was a perceptible shift in focus to rural India, with various schemes announced. Perhaps the most interesting was the “Modi-care” initiative targeting 100m poorer households with basic healthcare coverage of 500k rupees (nearly US$8,000) per family per year. 

While much focus is devoted to the annual budget from the central government, the aggregated budget of all of India’s states is 90% larger than the centre. For example Utter Pradesh, India’s most populous state, is planning to spend the equivalent of 21% of net central government expenditure. We are seeing a ramp up in expenditure and a push for project execution at both a state and central level that has all the hallmarks of the political calendar becoming increasingly important.

State elections

This year we have eight state elections with Karnataka, Madhya Pradesh and Rajasthan being the larger ones. While these elections in themselves will not particularly alter the political balance in the short-term, they will clearly be important from a sentiment perspective. This will be increasingly true as we head towards the national election which has to be held at some point in the first half of 2019.

At the beginning of February, the state elections kicked off with three elections in smaller states in the north-east. The Bharatiya Janata Party (BJP) won all 3 with the victory in Tripura particularly noteworthy as the party went from having no seats to winning a majority.

As it now stands the BJP control 21 out of 29 states, covering nearly 70% of the population:


Source: CLSA, Election Commission

One outcome of the state election schedule is that the chance of bold new reforms before the national election in 2019 are low in the near-term. Government will be focused on the execution and implementation of already enacted reforms.

We would also view the huge increase in domestic participation in India’s capital markets partly as a consequence of government action making it risky to hold cash and partly through demographic change and technology.


India has undergone significant pain over the last couple of years as a number of actions/reforms have been implemented; the main ones being demonetisation, GST and the RERA Act - tightening regulations in the real estate sector. Ultimately the aim of these actions is to make governing India easier.

A key message running through the last government-produced Economic Survey is the growing number of workers and firms being brought into the formal economy (and therefore subject to taxation and greater regulatory oversight). At its most basic level, one of India’s traditional problems has been understanding what was really going on in the country. With the majority of the population living in rural areas and with most people earning their living in the informal parts of the economy, it has always been a monumental task producing policies that are effective, efficient and actually reaching the intended target. Many recent government initiatives have been all about encouraging both people and businesses to enter the formal economy, be it by incentives (GST) or rather more blunt measures (demonetisation).

Formalising the economy will take many years but there have already been signs of some success, even if parts of the informal sector have shown remarkable resilience. We have seen a decent increase in newly registered taxpayers, a significant increase in electronic payments as well as an explosion in new bank accounts.

Newly registered Indian taxpayers (millions)


Source: Economic survey, Capital Economics

We would also view the huge increase in domestic participation in India’s capital markets partly as a consequence of government action making it risky to hold cash and partly through demographic change and technology. India is a young, technologically savvy country that benefits from some of the lowest mobile data packages on the globe and some of the best private banks and financial institutions who are developing more innovative ways to enable the population to access the markets. This is of course only possible due to India’s unique Aadhaar identity programme and the way it is being used to transform virtually all activity in the country.


Corporate fundamentals are looking the best they have for many years. The emergence of green-shoots of recovery in the macro data is also showing up in certain sectors at a corporate level. While we would not attach too much importance to short term quarterly numbers, we do look for trends.  The combination of supportive global growth, improving capex, fiscal spending and the buoyant consumer bode well for growth. Cash flow generation looks very strong, and operational efficiencies are apparent as asset turn is at a post global financial crisis high and return on equities (ROE) have begun to improve.

The continuing NPL issues with the public sector banks was expected, but there were better than expected recoveries in the consumer and housing sectors as well as materials and energy. The order trends in the capital goods space was also a positive surprise. Overall this quarter’s results do indicate momentum is picking up domestically, although there are still one or two pockets of stress. Consensus on the Street now estimates earnings growth for the Nifty/MSCI India universe at 12/11% for FY18 and 22% for FY19.

With increased evidence of a recovery coming through, we think 2018 equity market returns will likely be more influenced by top-down macro factors than we have seen for some time. We think cyclicals should make a comeback after an extended period of underperformance due to economic disruptions. The market has been led by structural growth stocks and sectors such as the consumer staples and discretionary sectors as well as selected energy and materials stocks that have benefitted from rising international prices of their core products. Valuations of domestic structural growth stocks and sectors are very rich against history.

The more cyclical sectors, such as financials and in particular corporate focused banks, as well as some infrastructure related areas have not performed particularly well, and exhibit a considerably better valuation buffer.

Our positioning

Over the last year we have been actively increasing the exposure of the portfolio to a domestic recovery. The impact of demonetisation and then GST did constrain growth and hence the more cyclically exposed sectors underperformed most of last year. The consequence was that valuations for structural growth sectors which are less reliant on short term economic growth such as consumer staples are trading at historically very high valuations as investors herded into these pockets of the market. Therefore the more cyclical sectors have a better valuation risk-reward profile and provide greater upside potential from the long awaited economic and earnings recovery ahead.

Our positioning domestically is achieved through a number of different sectors. Our largest sector weight is to financials – particularly the corporate banks and select non-bank financials that are exposed to structural growth such as housing. Corporate banks in India are trading at a significant discount to the more retail focused banks, and while there are still issues that need resolution we find that valuations are attractive.

We have retained large overweight positions to the consumer discretionary sector, as well as industrials. We also have good exposure to the IT sector where we see valuations are historically cheap and it is an area that is benefitting from the improved global economy. Our largest active position is having no exposure to India’s energy sector and is due to both valuation and governance concerns. We also retain a large underweight to consumer staples, a sector with particularly eye-watering valuations and also some governance concerns as well.

Overall we remain very positive about the outlook for India and its markets. Narendra Modi has been in power for nearly four years and we believe India is on a path to a more sustainable and higher growth trajectory than it was before he was elected. That can only mean good news for the many world-class Indian companies that can grasp the huge opportunity ahead.

[i] Insolvency and Bankruptcy Code