An Indian Vote Of Confidance

The Indian government recently won a hard fought vote of confidence as part of its effort to secure a controversial nuclear power pact hashed out with America. Now we will wait to see if some of this confidence in the political arena can help boost investor sentiment in the stock market. There are a number of reasons, in our view, to believe it can.

This is due primarily to the new look of the ruling coalition which is still headed by the Congress Party and the reformist Prime Minister, Manmohan Singh. For years holding back more comprehensive reform in India was, in our opinion, the minority coalition Communist party partner.


The loss of Communist support due to the nuclear deal with the US left the government in search of a new partner. In the event, it was the Samajwadi Party that joined the coalition thus maintaining a parliamentary majority.

Having won the confidence vote in last month, new elections are now not likely to occur until the spring of next year (May 2009 at the latest). With new found political momentum, this leaves enough time for a reform agenda to be advanced albeit in the context of the upcoming elections.

And reform can be a powerful force in India. In the 1990s, it was Mr Singh, then as Finance Minister, who led reforms that laid the groundwork for the countrys higher sustainable rate of growth we have witnessed in the recent past. A rate in keeping with Indias dynamic and astute corporate sector.

Very often when talking of restraints on Indian economic growth, the first topic addressed is inevitably infrastructure and with good reason given the well documented need to upgrade everything from roads to ports to schools. However, loosening the ties of bureaucracy and regulation that reform would bring is equally important.

Already changes being floated in the insurance and banking sector aiming to entice more foreign investment look promising. Add in potential pension reform and privatization, which will require significant heavy lifting, and we believe India is capable of returning to the solid 9 percent economic growth the West has become accustom to.

Such tangible results may have wait as growth slips back towards 7-8 percent in the year ahead, however these changes can have a more immediate impact on outlook and investor sentiment. This would be welcome given the domestic stock markets recent volatility.

Since reaching a high 21207 in January, the SENSEX has undergone a significant correction. Over this time, the index has declined by as much as 40 percent, touching a low of 12515 in July.

Encouragingly, the major lows from 2007 at 12316 remain intact. This support coincides closely with a 50 percent retracement level of the 2003 to 2008 rally. In the months ahead, we anticipate a period of consolidation above this support, which will in turn, keep alive the potential for an eventual revival in broader upward momentum.

There was no question as we entered 2008 that the stock market was overextended and in need of a healthy correction to restore some balance. The average price to earnings (PE) ratio of the index was trading well above the long-term average of around 20 times in early January when it briefly exceeded 30 times. That said, we have been disappointed by the size of the pullback we have witnessed since the start of the year.

According to the Bombay stock exchange, the index in April was back trading on a trailing PE of less than 21 times. However considering the market has moved lower in the interim this figure is almost certainly lower now. Factor in moderate growth in corporate earnings (in the case of India this is between 15-20 percent) in the year ahead and the prospective PE is even lower, which in our view provides a better foundation for future growth whilst also limiting further downside.

A banana skin which India will need to avoid in todays economic climate is the threat of runaway inflation. Already the country is wrestling with inflation growing at a 13 year high. The Reserve Bank of India (RBI) was in our view slow off the mark in reacting to this danger. However, since June the RBI has raised rates by 1.25 percent and cash reserve ratio requirements at banks by 0.75 percent.

We believe that more will need to be done as inflation has got off to an unfortunate head start. However, now that the RBI is engaged we are optimistic the rot can be halted before inflation becomes too entrenched. This will also make the choice of a new RBI governor in September even more important than usual.

It also highlights why the efficiency and productivity gains that reform can contribute are so important. As we have seen in America, when inflation is rising and growth slowing, monetary authorities must tread a fine line.

However, we continue to believe that Indian equities are in a secular bull market and as such, the recent correction has not derailed our long-term investment case for the region.

We believe the underlying fundamentals remain overwhelmingly positive for the country's future prospects. And in this context, the Indian stock market should over the long term out-perform.

And investing in India is a long term proposition. During that period there will be inevitable ups and downs. We believe we are experiencing such an episode today to the downside. This however does not change our overall bullish view and confidence in the robust growth story that is India.

With a middle class expected to grow by a multiple of ten to over 500 million in the years ahead, we believe an internally driven market will in time help power India into the worlds economic heavyweight division. Add to this the substantial domestic investment required to upgrade the countrys infrastructure and the future becomes brighter.

If the government can continue to do away with the impediments that have held back foreign investment, a further shift into services industries is likely which will further boost economic vitality. Indeed, we believe the race towards a higher standard of living and sustainable growth is Indias to lose. Having successfully embarked on the journey thus far, the country will continue, in our opinion, its steady progress towards fuller development.

In this context, we expect the business community and the companies listed on the Indian stock market to both enable and benefit from the changes. As such, we recommend investors retain exposure to Indian equities during this current downturn.

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