IN FOCUS6-8 min read

India: sky high valuations could dampen investors’ festive spirit

As the festival season gets underway in India, market valuations suggest the mood music remains upbeat. But there are doubts as to whether these can sustain at current levels.



James Gotto
Emerging Markets Fund Manager
Andrew Rymer, CFA
Senior Strategist, Strategic Research Unit

Global growth is slowing as the consequences of Russia’s invasion of Ukraine continue to emanate, and as major central banks respond to high inflation. A slowdown in China, now the world’s second largest economy, only exacerbates this.

One country which has so far been far more resilient is India, which overtook the UK to become the world’s fifth largest economy in the final quarter of 2021. GDP growth accelerated to 13.5% year-on-year (y/y) in Q2 of this year. Of course, activity has been amplified by the ongoing Covid pandemic recovery, which looks set to cool over coming quarters. With strong potential growth of around 6% a year though, the longer-term outlook for India’s economy still looks comparatively robust.

This promising macroeconomic outlook goes some way to explaining why India has been more resilient relative to broader EM equities this year. The MSCI India is down -9.6% year-to-date, compared with the MSCI Emerging Markets Index which has dropped 26.9% as at 18 October. There is more to the story though, in particular on the market valuation front, as we explain.

The long-term outlook for India’s economy is positive

While the long-term picture for India’s economy remains very attractive, we expect the pace of growth to slow in the coming quarters, albeit from high levels. Tighter liquidity, as the central bank lifts interest rates in response to higher inflation, in combination with a negative turn in the fiscal impulse as government spending slows, look set to dampen activity. The post-Covid recovery may continue but is likely to fade.

In addition, one point we have been monitoring for some time is the uneven recovery across the economy. There is a clear K-shaped recovery with higher income groups prospering as a result of factors such as salaried employment and savings. Conversely, job creation and wage growth among lower income groups has been weaker, and their savings are typically more limited. This is partly explained by increasing levels of automation in the economy and reduced competitiveness in traditional labour-intensive industries. A sustained period of high inflation could exacerbate this.

Long-term growth is supported by a combination of population growth of close to 1% per year, and labour productivity. The working-age population has picked up from 64% in 2011 to around 67%, and is rising by around 1.4% annually. Labour productivity growth is being driven by various factors including urbanisation, digitisation, investment and reforms. However, it is worth noting that labour force participation has been falling for the last decade, so job creation is a challenge.

Of course, this positive outlook is not without risks. Reform progress has been well flagged under Prime Minister Modi. However, assessing the extent to which these have impacted longer term growth trends has been masked by the Covid pandemic. There is scope for additional reform but this will depend on politics. It is also worth noting that India is highly exposed to climate risks. The annual monsoon season, which runs from June to September, is important for both the rural and wider economy. This year, average rainfall was at 106% of the average, but distribution was uneven. As a result, drought in some areas such as Uttar Pradesh in the north may see lower levels of crop sowing.

The pathway for inflation

Like elsewhere in the world, inflation has been rising in India, particularly energy and food prices. Higher crude oil prices have been negatively impacting the current account, translating to foreign exchange reserve losses and rupee weakness.

The headline rate climbed by more than expected to 7.4% y/y in September, led by higher food prices. Inflation is above the central bank’s target band of 4%+/-2%, and the monetary policy rate was increased by 50bps to 5.9%.

Since April this year, the Reserve Bank of India has been increasing interest rates from the Covid pandemic low of 4%. Further rate hikes could follow in the near term, given ongoing currency weakness, but the pace of tightening will depend partly on the global interest rate environment, and could slow as the lagged impact of previous hikes comes through. The government responded to concerns around lower levels of rice planting by banning rice exports. Food accounts for almost 40% of the headline consumer price index. There have been other interventions, in an attempt to smooth the impact of higher commodity prices on inflation, but these could incur a fiscal cost.

Fiscal and current account pressures

On the fiscal side, medium term consolidation is planned, with the goal of reaching a deficit of 4.5% by 2026. This is needed in order to keep government debt-to-GDP controlled; it currently sits at close to 90%. The budget for the fiscal year ending 2023 targets a deficit of 6.4%, a fall of 0.5%, but this seems unlikely to be reached due to higher food, fertiliser and other subsidies. Another area of doubt over the durability of these consolidation plans stems from the general election scheduled for 2024. Indeed, there is risk that as spending slows, subsidies are prioritised over investment, though India has laid out ambitious infrastructure investment plans, to reduce logistics costs.

The external accounts have come under pressure this year in the face of higher crude oil prices, as India is a net importer. The economy is vulnerable to a sustained period of higher energy and other commodity prices, given the stickiness of inflation. The combination of the current account deficit, together with a rupee which is above its long-term average on a real effective exchange rate basis, means there is a risk of further currency weakness.


Politics and the reform outlook

Since his election in 2014, Prime Minister Modi has delivered a series of structural reforms. Modi has relaxed foreign direct investment (FDI) policies, and allowed greater foreign investment in several industries, including in defence and railways. Among the most important reforms enacted over the last eight years are Aadhaar, the world’s largest biometric identification system, an insolvency and bankruptcy code, and a goods and services tax to replace a complex system of central and state taxes.

There is a medium-term opportunity for India as global supply chains become more diversified, reducing reliance on China. This would likely require additional reform and/or policy adjustment, and it is still unclear as to the extent India can capture these opportunities. That said, several Production Linked Incentive Schemes have been launched to encourage investment in targeted industries. India’s economy is less open relative to other EM and historically India has been more protectionist in relation to international investments, often favouring domestic companies. While Modi has eased FDI policies, he has also promoted his vision of Aatmanirbhar Bharat, which was launched in 2021 and effectively means self-reliance.

Reform progress has been encouraging, but the agenda remains significant and implementation may be dependent on the amount of political capital that Modi’s Bharatiya Janata Party (BJP) retains. There are a limited number of state elections next year, but the 2024 general election will increasingly become a focus. This could drive more populist policy making, and increasingly limit the prospect of further reforms. For now the next significant changes in the pipeline appear to be reforms to direct taxes via the removal of some exemptions and a simplification of tax rates.

Valuations are still eye-watering

Despite some moderation, aggregate valuations in India are the most expensive in the MSCI Emerging Markets Index. Relative to history, the 12-month forward price-earnings and price-book ratios (shown below) are both above the historical median.


When compared with broader EM, the MSCI India Index trades on a 12-month forward price-earnings ratio premium of more than 100%. On a price-book basis the premium is closer to 130%. As the next chart illustrates, India has historically traded at a premium to the MSCI Emerging Markets Index. However, this premium is now at extremely high levels. Return-on-equity has also been at a premium to broader EM, but it has come down in recent years. Indeed, earnings forecasts are currently being revised down.


Why these valuations may not persist

An important driver of the high valuations in recent years has been domestic reform, which has been the catalyst for a mobilisation of domestic capital. This has spurred strong flows into the market, which have continued, even at times when foreign investors have been net sellers. Domestic flows remain positive but have slowed and, amid a broader environment of rising interest rates and tighter liquidity, and expectations for weaker earnings growth, there is good reason to think that this support may not sustain.

Long term positive; short term negative

India offers much promise from an investment perspective. Whether it is the next great convergence story is another debate, but longer-term economic prospects remain relatively strong, especially in a world increasingly short of economic growth.  

For investors though, the sky high valuations of the Indian market mean that opportunities are more stock specific. Previous reform progress has been positive but policy is tightening, which could result in a cyclical slowdown in growth, an eventuality not discounted in the market’s valuations.


James Gotto
Emerging Markets Fund Manager
Andrew Rymer, CFA
Senior Strategist, Strategic Research Unit


The value of an investment and the income from it may go down as well as up and investors may not get back the amount originally invested.