India: brewing second wave overshadows the outlook

India’s economy bounced back quickly after the stringent lockdown in March last year. GDP growth actually returned to positive territory in the final quarter of last year, rising 0.4% year-on-year (y/y). The rebound was partly driven by India’s apparent success in controlling Covid-19, enabling the economy to largely re-open.

After peaking in September, coronavirus cases in India came down significantly in the last few months of 2020. This was puzzling in itself as there were no new restrictions on activity, leading many analysts with little choice but to point to herd immunity. Irrespective of how it was achieved, the news provided a welcome boost to the growth outlook. The consensus economic growth forecast has increased to 9.3% y/y for this year.

However, over the past month we have become increasingly concerned over a brewing second wave of the pandemic in India. Especially as the vaccination programme has got of to an underwhelming start.

India behind in the vaccine race

India is lagging behind in the vaccine race, relative to other emerging markets. Granted, this is partly because of its vast population of 1.4 billion people, but the government is also falling short of its own target of vaccinating 300 million people – or one fifth of the population  - by August.

The problem has been demand. Uptake of vaccines has been disappointing, and so far only 3.3% of the population have had their first dose.

The stark rise in daily new cases Covid-19 in recent weeks, highlighted in the chart below, suggests investors can no longer brush aside the slow vaccine roll-out. New cases have mainly come from Mumbai’s state of Maharashtra (14% GDP), which has accounted for over half the new infections. But other states have also experienced a significant rise in cases including Punjab (2.8% GDP), Madhya Pradesh (3.6% GDP) and Karnataka (7.8% GDP), the  home of technology hub Bangalore.

Prime Minister Modi was quick to speak to Chief Ministers, as the heads of the state governments are known, last week. Modi emphasised the need to step up testing and ramp up the speed and efficacy of the vaccination programme.

As a key global producer of vaccines, this is already having implications for the supply of vaccines for the rest of the world. Vaccine delivery to the UK and Brazil were delays and now, India has announced that it is temporarily banning all exports of the Oxford-AstraZeneca coronavirus vaccine. This is expected to last until the end of April.

What does this mean for economic growth?

Tighter restrictions, including night curfews, which have been introduced by state governments in Covid-19 hotspots, are likely to have a detrimental impact on growth. As a result, we now see downside risk to the 11% figure we had pencilled in for this year.

The impact on growth from the additional restrictions announced so far should be reasonably contained. But the risk of more widespread lockdowns is now elevated, and would require a significant downward revision to our GDP growth forecast for this year.

Low level activity data – such as trade, vehicle sales, steel and cement production – suggest that growth already slowed slightly in January, as the chart below shows.    

The second wave and risk of further restrictions will also likely make the Reserve Bank of India (RBI) very uncomfortable. The initial lockdowns proved inflationary, as supply side constraints resulted in cost-push inflation.

The RBI is already faced with rising core inflation is rising and higher commodity prices and are yet to fully feed through to inflation. However, it is likely to focus on any detrimental growth impact and delay its planned withdrawal of liquidity.

What does this mean for investors?

For equity investors, the downside to GDP growth has implications for company earnings, which have a reasonable relationship with domestic economic activity, as the next chart illustrates. This stems from India having a relatively domestic equity market, with companies generating around three-quarters of revenue in country.

For now though, our indicator suggests earnings should continue to improve in the short term, and will benefit from base-effects in the second quarter.

The backdrop is one where India’s valuation is one of the highest in emerging markets, as shown below. From a top-down perspective, the price tag attached to India’s equity market is underpinned by India’s long-run growth outlook. This is clear from the relationship between the price-to-earnings ratio and the IMF’s potential growth estimate.

In our previous work, we found that India’s potential growth rate is likely somewhat lower that the IMF estimate; around 6%. So despite the latest budget, which includes measures to improve medium term growth, India’s valuation is still a challenge for equity investors.

The situation is clearly rapidly evolving, but a second wave provides downside risk to growth and may force investors to take another look at the high valuation hurdle for Indian equities. Meanwhile, more lockdowns would likely force the RBI to delay any withdrawal of liquidity and any supply driven inflation would be unwelcome for India’s macroeconomic stability.