Can India meet optimistic growth expectations?

India's prospects for economic growth look good - but we think its promise is already priced into its stock market.

By Rathbones Investment Management 10 May 2024

Slowing economic growth and rising geopolitical risk have made China an increasingly unattractive destination for investment, as we highlighted in our report on China last year. That shifted the spotlight to India — the most populous nation in the world with a recent track record of strong growth and better relations with the West. But can India live up to the hype and deliver the sustained strong growth many expect?

Our analysis suggests that India may indeed grow much faster than any other large economy over the next decade. Yet investors should tread carefully when trying to tap into this positive story. Strong economic growth is contingent on further progress in some key policy areas. And in aggregate, an awful lot of good news is already priced into India’s stock market. Therefore, caution and a more selective approach than simply buying the whole market are warranted.

Plenty of scope to catch up

Excluding China, India has probably grown faster than any other member of the G20 group of 20 major economies over the past 10 years (problematic national accounting data make it hard to be sure), with GDP growth averaging 5.6% between 2012 and 2022, according to official government data. India’s growth has propelled it from the world’s tenth-largest economy in 2013 to fourth today. Even so, India’s development is still in its early stages — it’s about as far behind the US as China was in the early 2000s.

As we did for China in last year’s report, we’ve broken down the outlook for India into the three drivers of economic growth over the long run — labour, capital and productivity. All three are likely to be a drag on growth for China, and there’s better hope for India across them all. But there are some key risks and areas to monitor along the way.

Some untapped labour potential

Overall GDP growth tends to benefit from the increase in the total number of workers in the economy, and there are now roughly as many working-age people in India as there are in China. What’s more, China’s working-age population is now in decline, whereas India’s is not projected to peak until 2050. That boost is fading, though. The growth rate of India’s working age population has already halved from 2.5% per year in the 1980s to around 1.25% today, and is likely to continue to slow for the next 25 years or so.

Made with Flourish

Source: UN and Rathbones

A second variable determines the contribution of labour to GDP — the share of the working-age population that participates in the labour force (those in or looking for work). In India, that rate for women is particularly low. Prime Minister Narendra Modi has set a goal of 50% female participation by 2047. If realised, that second wind of labour force growth could boost GDP growth by up to 1 percentage point per year relative to a scenario where female participation held steady. The untapped potential is huge, but experience suggests that unlocking it will be challenging.

Investing more in the future

China and India have had opposite problems in recent years — overinvestment versus underinvestment. India’s investment rate has never sustainably reached the highs seen in China or other East Asian success stories, and it has fallen over the past 15 years. As a result, there are significant unmet investment needs throughout India.

Fortunately, there have been some encouraging signs on this front recently. We think there are three reasons to be optimistic that India can deliver a turnaround in investment in the next few years. First, the government has finally begun to ramp up public investment. Second, the private sector now seems in a better position than it was a few years ago — banks are more able and willing to lend than in the past, company balance sheets are generally in good shape and earnings growth is strong. Third, at the household level, India has made remarkable progress on financial inclusion in recent years, which should help direct more savings towards firms needing capital.

A better outlook for productivity

As with investment, we think there are good reasons to be positive on productivity in India. One area where there is significant potential is in the structure of the labour market. India’s highly productive services sector accounts for 55% of value added by the economy, but employs only 35% of the workforce.

The agricultural sector is the opposite, employing 40% of workers but accounting for just 15% of value added. Continuing the transition from agriculture to services may help to raise productivity. Meanwhile, policymakers have recently started to address the problems of underemployment and skill mismatches in the labour market, beginning the process of streamlining India’s rigid and complex employment laws. But there’s a long way to go on this.

Meanwhile, climate change is a key risk to long-term productivity growth in India, with climate modelling highlighting it as the most vulnerable large economy. Quantifying the likely impact precisely is nigh on impossible, but there’s already clear academic evidence that rising temperatures have hurt productivity growth in the most exposed emerging economies, so this is worth taking seriously.

Don’t ignore India, but tread carefully

India’s economic story is too significant to ignore. Despite the risks, there’s good reason to think that it will be able to sustain much faster growth rates than any other large economy over the next decade. But investing in India isn’t straightforward.

The profits of Indian companies, which are largely earned at home, are likely to grow faster than those of their peers in most other major markets. But currently the price you pay to access them is high relative to history and to the rest of the world (see graph). India’s stock market currently trades at about 22 times this the coming year’s earnings, compared to 12 ten years ago and about 12 for emerging markets generally 

Made with Flourish

Source: LSEG and Rathbones

Headline measures like this can occasionally be misleading, as they don’t reflect the underlying composition of a market. Yet in India’s case, correcting for this doesn’t change the story at all. Even if we adjust for the sectoral composition of the market, and other relevant factors like firms’ track records of growth, India’s equities still show up as relatively expensive. Firms in the same sector with similar growth records are generally much cheaper in other emerging economies.

In other words, whichever way we cut it, Indian stocks already seem to be discounting a very rosy long-term outlook. Investors in the market are already banking on earnings growth substantially faster than seen over the past decade. So even if the fundamental story remains strong, this may not be a great entry point, at least as far as the broad market is concerned. It’s worth remembering the lesson of China’s experience in previous decades — fast GDP growth alone doesn’t guarantee superior market performance.

Even so, there may still be more attractive opportunities in certain sectors, which argues for taking an active approach rather than passively investing in the index as a whole. Indian consumer and property stocks are particularly expensive, but the difference to the rest of the world is smaller elsewhere.

Overseas companies benefiting from India’s economic growth could be another route for investors to gain exposure at more attractive prices. And even if returns aren’t as impressive as over the past decade, Indian stocks may still provide some useful diversification in our view. Compared to other large emerging markets, both stock prices and profits in India have only limited exposure to developments in China, the US and Europe.

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