The Elephant and the Dragon – A Tale of Two Markets
The Indian and Chinese economies have both been growing at exceptional rates in the range of 9-11 percent per annum. Their equity markets have registered huge gains. India’s SENSEX index for the Bombay market rose 48.5% last year and the iShares FTSE/Xinhua China 25 (FXI).for major Chinese companies listed on the Hong Kong Stock Exchange advanced by more than 84%. Commentators have expressed concerns about possible overheating in both countries. However, we see some significant differences between the two situations. These have led us to follow a differentiated investment strategy, underweighting India while overweighting China in our Emerging Market Portfolios. Our January 22, 2007, Commentary explained our positive strategy and approach for investing in China. Below we discuss why we are taking different approach towards India’s equity markets.
After decades of under-performance, economic reforms are resulting in India being well on its way to becoming the third largest economy in the world, overtaking Japan, if measured by purchasing power parity. This is a remarkable achievement, what the Financial Times has called India’s “long-awaited coming-out party”; but warning signs are now flashing that the economy is in risk of significantly overheating. The lead article in the February 3, 2007, issue of The Economist, “India Overheats” outlines the growing concerns.
With growth advancing at the most rapid pace in 18 years, the economy is encountering various capacity constraints and infrastructure bottlenecks. Despite the market-opening reforms undertaken since 1991, excessive government regulations, including rigid labor laws, still remain a heavy burden on the private sector. According to a recent survey, essentially all firms (99%!) consider that they are operating above optimal rates. Another indication of the excess of domestic demand over supply is India’s current account deficit. It was equal to 2.3% of GDP last year and is projected to grow to almost 4% of GDP by 2008. The contrast with China’s current account surplus of 9.1% of GDP last year is striking.
India’s infrastructure (roads, rails, ports, power) is sorely inadequate. There are serious shortcomings in basic health care and the provision of drinking water. Skilled labor is in short supply due to shortfalls in both basic and secondary education. A stunning statistic is the illiteracy rate for women of about 50% (in China the ratio is one in seven).
Boosting supply by attacking the above problems is a priority for the government but will take time. The current weak budget situation will be a constraint. The Prime Minister, Manmohan Singh, is an economic reformer, but his coalition government includes the communist parties which resist many of the needed reforms.
It is, therefore, not surprising that prices in India are now advancing at a disturbing pace. Wages and property prices are soaring. India’s wholesale price inflation jumped 6.73 per cent in the 12 months to February 3. This is more than twice China’s inflation rate which is well below 3%. India’s inflation is now running significantly above the Reserve Bank of India’s “comfort zone” of 5-5.5 per cent. The RBI has been rather timid in tapping on the brakes to cool domestic demand and now finds itself distinctly behind the curve. Credit growth at an annual pace of some 30%, twice the rate in China, is feeding this inflation.
The spectacular growth of the Indian economy is threatened by these alarming signs of overheating and emerging asset price bubbles. While India’s equity prices in 2006 advanced by “only” 48.5%, they have risen over 400% over the past 4 years. Portfolio investors, sensing that India’s markets have gotten ahead of themselves and that a correction is overdue, have become increasingly wary. The SENSEX declined 5.4% during the week of February 19, and is down 1.1% so far this year. Further moves by the government to curb inflation could be the trigger for a more substantial adjustment.
We share the concerns about the apparent current overbought situation in India’s equity markets and the overheating of the economy. We anticipate that the current decline in Indian stock prices has further to go. But we also consider the medium to long term prospects for the Indian economy to be good. The second largest and second fastest growing emerging market economy belongs in emerging markets equity portfolios. We are maintaining our underweight India position in Cumberland’s managed Emerging Market ETF Portfolio for the time being. We would view a significant downward market adjustment as a buying opportunity and would consider then moving up to a neutral or even an overweight position for India.