Can India replace China as the world’s growth engine?

Key Points

• With more than a sixth of the global population in India, growth prospects are even more vital. For now, the economic outlook is encouraging though there are risks
• Indian financial markets have been relatively unscathed by turmoil that the SVB and Credit Suisse bank issues had in American and European markets in March
• Domestic bond markets reacted well to the central bank’s decision to keep the repo rate at 6.5% in April 
• First-quarter company earnings season is in full swing. Results show that capital expenditure remains popular with the Indian banking sector performing admirably in the face of a tough global backdrop. That said, the equity risk premium is not very attractive at the moment, one reason for being tactically neutral stocks

India is about to achieve the milestone of replacing China as the world’s most populous economy, the United Nations Population Fund's (UNFPA) "State of World Population Report" expecting the event to occur “mid-year”¹. At 1.43 billion people, over a sixth of the global populous would reside in the country. 

In addition, India’s citizens are relatively young. A whopping 34.8% of its people are under 20, while China’s figure is 23.2%², as the population ages. That said, India’s economy will need to expand and attract investment quickly enough to support this pool of workers, and in turn support global growth. While not a mission impossible, it could be a hard act to achieve.    

India largely immune from the effects of American and Swiss bank collapses

Turning to the more immediate future, for once investors are more focused on the aftermath of the demise of Silicon Investment Bank and First Republic Bank in the US and Credit Suisse in Switzerland, than on central bank policy on interest rates or where inflation is heading next. The initial signs are encouraging with rescue operations being successfully administered. However, many banks are probably experiencing similar difficulties following the speedy lifting of rates in the US last year, and the impact that has on their finances. 

In India, the US and Swiss bank collapses had relatively little effect on its financial markets, investors taking the view that the risk of events reaching the country’s shores was minimal. For instance, 5-year Indian government security yields had fallen to 7% on 2 May from 7.25% on 15 March, mid-March seeing yields in Western bond markets spike, according to Bloomberg data. Meanwhile, in the country’s corporate bond markets, 5-year yields dipped to 7.48% from 7.68% over the same period.    

Interest rates on hold while the economy chugs along

While the US Federal Reserve and the European Central Bank show every sign of bearing down on inflation despite the tighter financial conditions from recent troubles in the banking sector, the Indian central bank surprised the market by keeping the key lending rate, or repo rate, at 6.5% in April³.

The central bank pointed to the resilience of India’s economy and growth data. On inflation prospects, after dipping to 6.4% in February, the Reserve Bank of India (RBI) expects it to average 5.2% in the twelve months between April and March 2024 (or financial year (FY) 2023-24)³. Meanwhile, gross domestic product is expected to nudge up to 6.5% in FY 2023-24 from 6.4% in the prior year. 

Indeed, April's monthly high of INR 1.87 trillion in government sales tax collections, manufacturing purchasing managers' index at 57.2, robust coal output, fuel demand and auto sales are symptomatic of a strong domestic economy.

 That said, the RBI is wary that sticky core inflation and external economic or geopolitical shocks may alter planned policy on rates. All in all, the central bank’s pause in rates is largely attributable to its intention to allow past rate hikes to percolate through the system and its comfort with inflation trajectory. 

As such, we believe that repo rates have peaked and that the central bank will hike again only if incoming data provides a compelling case for it. 

Pause in rates good for bond market

The bond market reacted positively to the wait-and-see stance of the central bank at its April rate-setting meeting, having expected a 25-basis point (bp) hike. We remain overweight bonds with an investment horizon of 18-24 months. 

The duration curve continues to be on the flat side, with 3-year term spread around 40bp, the 5-year around 50bp and the 10-year at around 70bp, according to Bloomberg data. As markets adjust for a rate pause and anticipated cut, the yield curve is likely to steepen with the shorter end dipping more than the longer end. Also, credit spreads remain attractive for investors with appropriate risk appetite.

Assuming the repo rate remains in the 6.50%-6.75% range, a blended portfolio of 3- to 5-year government and high-quality corporate assets is one way to play the market over an 18 to 24-month period. The strategy can provide healthy returns, primarily by locking in higher accruals with the roll-down effect while a so-called bull steepening in the yield curve would add capital gains. That said, this approach is not for the faint-hearted given likely heightened bursts of higher volatility.

Deciphering the earnings’ message

The Indian corporate earnings season is providing some colour on the state of the impact caused by slowing global growth and health of the local economy. Among the highlights that have popped up so far:

• A new-deals slowdown in the information technology services underlies a lowering of full-year guidance for some of the biggest players in the sector. 
• Meanwhile, sales momentum chugs along among vehicle manufacturers and electric vehicle adoption gains pace.
• Bank profitability levels are encouraging, with some household names reporting highs for their return on assets and net-interest margin ratios. As such, investors will likely remain enthusiastic about prospects for the sector.

In addition, capital expenditure (capex) remains in vogue, reflected in expansion in new factory orders leading to higher capacity utilisation and demand for the Production-Linked Incentive scheme. 

The Nifty50 index of the 50 largest Indian listed companies continues to trade in a narrow range around its long-term average. Within the broad-based equity markets, niche opportunities can be found, especially among small- and medium-cap companies.

While we like domestically-oriented businesses, like autos, consumer durables and non-durables, capital goods and infrastructure, at current valuations, select opportunities can also be found in some export sectors such as pharmaceuticals.

Beware of potential risks

While Indian equities, and assets more generally, have much going for them, many risks should be bourne in mind. The coming Monsoon season might hit economic production, the only question is to by how much? In turn, this has a risk for the inflation outlook (and so the direction of interest rates). 

While the oil price may be under downward pressure from weaker global growth prospects, any surge in the price over a sustained period, say over $100 a barrel, although far from the current levels and our base case, could hit India’s economic outlook and company profit margins.  

Less visible, and in the medium term, the approaching central government elections early next year do not seem to be reflected in the market volatility levels. This can be seen in the Nifty50’s VIX’s, or the fear gauge, being close to a 5-year low at the beginning of May, according to Bloomberg data. This means that the equity risk premium is not very attractive, underpinning our neutral stance on Indian equities.

Alternative assets

The volatility seen in markets globally this year highlights the importance of diversifying portfolios to reduce long-term investment risk. In this respect, investing in private markets – across both debt and equity, can make portfolios more diversified.

With inflation set to remain high this year, investing in real estate investment trusts (REITs) and infrastructure investment trusts (INVITs) can hedge against the elevated speed of price rise. Both asset classes might offer respite should a low growth and high inflation period emerge (or stagflation). That said, recent taxation changes may act as a short-term drag on performance, so investments in such areas should be considered as long-term in nature.

This year is likely to remain a particularly volatile one, with clarity over the outlook for global growth, the rate of price increases and interest rates likely to take some time. At such worrying times, investors tend to flee to safe havens such as gold, which also acts as a portfolio diversifier or inflation hedge.