Can Indian market’s strong run continue? Here’s what Morgan Stanley predicts
The strong Indian economy and rally in the market have investors questioning whether this bull run can continue. Morgan Stanley believes it can. Here's why.
The strong Indian economy and rally in the market have investors questioning whether this bull run can continue. Morgan Stanley believes it can.
"We have been constructive on India’s outlook for some time, highlighting that India offers the best domestic demand alpha opportunity within Asia and one of the best structural stories over the medium term globally. A wide variety of growth indicators suggest that the economy is doing well. Investors we speak to are generally bullish and this has been reflected in a strong run in asset markets so far," it said.
Given this backdrop, the brokerage noted that the debate with investors is usually centered around what can sustain or derail the positive narrative on India.
"In our view, the most important driver to sustain growth and asset market performance is the investment cycle. To be sure, the investment cycle has already been inflected, driven initially by a sharp upturn in public capex. There are signs that private capex is picking up. It has been the shift in policy approach since 2019 towards supply-side reforms (acceleration in public capex, cutting corporate taxes, and the introduction of the PLI scheme as key pivots) and reduced emphasis on redistribution, which has attracted investment, unlocked the structural growth story," explained MS in a report.
In the report, it has addressed five common points of debates on India by cautious investors. Let's take a look:
Debate #1: Will higher US rates trigger a resumption of rate hikes?
As per the brokerage, when assessing the exposure of each economy to higher US rates, two factors matter – the starting point of bond yields and current account balances. Low yielders without the buffer of a sizeable current account surplus are therefore most exposed on this framework. In India's case, it noted that India’s policy rates are appropriately calibrated.
"Based on this framework, when we look at India’s inflation and current account balance, these macro stability indicators are in a comfortable position. Hence we do believe that policy rates are set at the right level and we don’t foresee the need for further tightening in our base case," it explained.
The brokerage pointed out that India's CPI inflation had breached the upper end of RBI’s target band in July and August on account of higher food prices, which raised investor concern about whether RBI would have to hike rate again to bring inflation back under control. However, the vegetable prices that spiked and led to this acceleration in inflation were of a short-duration nature and their prices have since reversed. Over the coming quarters, MS India economist, Upasana Chachra, expects that headline inflation will remain within the target range. It is against this backdrop that the brokerage doesn’t foresee a resumption of rate hikes.
Commenting on the current account deficit (CAD), MS informed that over the past 4 quarters, India’s CAD had been staying with the comfort zone – 2.5 percent of GDP – despite a robust expansion. MS India economist Upasana Chachra projects that the current account deficit will remain below 2 percent of GDP in both F24 and F25, suggesting that it will be well within the comfort zone and should not give rise to external funding concerns.
Moreover, while the rise in US rates over the last four months did put some pressure on most EM currencies, the rupee has been less volatile and MS believes a combination of improved macro stability and structural reforms supporting healthy capital inflows protected the trends in balance of payments.
Debate #2: What level of oil prices would stretch macro stability indicators beyond the comfort zone?
Any rise in oil prices tends to bring concerns about India’s macro stability indicators, believes MS.
"India remains a net oil importer with an oil trade balance of -2.6 percent of GDP. Within the region, India is one of the more exposed economies to higher oil prices, with every $10 rise in oil prices imparting a 50bps upside to inflation and could contribute to a 30bps widening of the current account balance. Moreover, this is compounded by the issue that inflation is still 1% point above the mid-point of the target band and that India tends to run a current account deficit," stated MS.
Currently, retail fuel prices are already marked to market at $90/bbl, so they have not had to be adjusted. Meanwhile, if oil prices were to be sustained around $95/bbl, the overall impact on India’s macro stability would be manageable but the upside to inflation would likely mean a delay to RBI’s shallow rate cut cycle, which MS had pegged for the start of Q2FY24. MS commodity strategist Martjin Rats expects oil prices to rise to $95/bbl in Q4 but to decline into 2024.
However, it warned that the risk arises if oil prices rise above $110/bbl in a sustained manner. Under this scenario, while there would still be some fiscal subsidisation, it believes that the pass-through to domestic fuel prices will increase. As adjustments to retail fuel prices are taken up, there will be upward pressures on inflation. Moreover, sustained higher oil prices would also mean that the current account deficit would likely widen beyond 2.5 percent of GDP, it added. With macro stability indicators stretched under this scenario, it predicts currency depreciation pressures could rise and lead RBI to restart its rate hike cycle.
Debate #3: Will infrastructure and skilled labour bottlenecks emerge as a constraint to the growth story?
This debate is more a medium-term one, said the brokerage. It believes that such constraints may potentially emerge in the next 18-24 months if the growth cycle continues to be strong. Policymakers are already taking a number of measures to increase infrastructure spending in a coordinated manner with the aim of reducing logistics costs. However, some bottlenecks will emerge and hence, taking these challenges into account, the brokerage has a realistic growth forecast of 6.5 percent on average over the coming decade. If the government does take up even more concerted efforts to expand the infrastructure network, there could be an upside to its growth estimates.
"The most critical component is to build up infrastructure in a timely manner that would improve logistical efficiency and bring down costs. In particular, resolving constraints related to the energy sector and the provision of electricity will be critical as India is building up its manufacturing base. Looking ahead, given the scale of infrastructure investments needed, we believe that there needs to be an immense amount of planning to ensure the seamless execution and rollout of infrastructure," MS noted.
For labor, the brokerage commented that continued human capital accumulation is needed to complement the expansion in industrial capacity expansion to sustain the growth trajectory. As is the case with infrastructure, there is progress from policy efforts to strengthen vocational training and further improve literacy rates. Over the medium term, MS sees some friction emerging on this front but as employment demand picks up, the government, corporations and workers are likely to respond, it added.
Debate #4: Why are FDI inflows slowing?
FDI inflows into India have declined from a peak of $70 billion on a Q4 trailing basis in 2Q21 to $33 billion in Q2FY23. With global GDP and trade growth softening, global FDI flows have softened, noted MS. Moreover, there are some sector-specific factors, such as funding for the internet and related sectors (from venture capital and private equity standpoint), that have slowed and are weighing on the aggregates, it added.
Another thing to note, it said, is that there are some implementation lags, where announcements have been made, but the actual investment has not yet flowed through. For instance, there is incoming newsflow on electronic manufacturing investment commitments coming from companies like Foxconn (which as per media reports had announced several billion in investments) and Intel recently announced its collaboration with eight companies to manufacture laptops in India, it further mentioned.
Debate #5: Will a weak coalition government lead to a shift in the favourable policy mix?
As per the brokerage, the constructive narrative on India is dependent on a continued focus on supply-side reforms. A continuation of this would be linked to the election outcomes. Maintaining policy stability will be key to keeping foreign and domestic corporate sector confidence buoyant, it noted.
"It is against this backdrop where MS believes that a stable, majority government will be able to continue to push through policy reforms, in order to sustain the shift in boosting private investment. This naturally turns the attention to the upcoming state elections this month and the general elections in May 2024. In our view, the key risk would be the emergence of a weak coalition government, which could result in a pivot back towards redistributive policies at the expense of the focus on boosting capex and implementing supply-side reforms," it cautioned.
According to Ridham Desai, MS Head of India Research and Equity Strategy, markets are seemingly pricing in an outcome of policy continuity, and he highlights that equity markets could turn lower in other scenarios.
Bottomline: India still the best domestic demand alpha opportunity
MS expects India's growth to be sustained at a healthy clip of 6.4 percent in F2024 and 6.5 percent in F2025, averaging 6.6 percent over F2024-28.
"India’s importance as a global growth driver will increase, with its share of global growth contribution has risen from 10 percent in 2021 to 15 percent in 2022, and further to 17 percent in 2023-28. On a USD basis, we expect India’s nominal GDP growth to accelerate to 12.4 percent in F2025 (vs 7 percent in F2024), outperforming China, the US and the Euro Area. The high terminal growth rate will mean India’s economy will compound at a strong rate on a high base. We expect nominal GDP will reach $5 trillion by 2027, making India the world’s third-largest economy," it forecasts.
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