As the world’s fifth-largest economy and most populous democracy, India is increasingly important for global investors and policymakers.

Since 2000, GDP growth has averaged 6.2% in the context of a unique development model. Unlike many fast-growing emerging market (EM) economies, which relied on manufacturing as their engines of development (China, Japan, South Korea, etc.), India’s service sector is its growth engine. Equally impressive, in the last decade, India maintained its healthy growth rates in a context of relative macro stability.

Since 2000, India’s economy has been one of the fastest growing in the world. The country moved from the world’s 13th-largest economy in 2000 to the fifth largest in 2023 (in nominal terms). In purchasing power terms, the best approximation of transaction volume in the economy, India is the third-largest economy globally. In 2000, India’s economy contributed a modest 4% to global GDP growth. By 2023, its growth accounted for 18% of global growth.

See also: Macro matters: India’s tax glitch

One factor that works in India’s favour is a growing diversification of global supply chains. In what is known as the “China Plus One” strategy, businesses are increasingly moving away from an overreliance on China. As companies seek to diversify their supply chains, the question is how much India stands to benefit vis-à-vis its emerging market peers.

A constellation of an improving investment environment, better infrastructure, a growing high-skilled workforce, and government subsidies have set the stage for India’s high-end manufacturing to increase its competitiveness. There have been some successes, with companies such as Apple and Samsung establishing phone factories in India, as well as progress in attracting “green-sector” manufacturing, such as electric vehicles and solar power.

ESG considerations

The environmental, social, and governance backdrop can present both risks and opportunities. On environmental policy, India has moved quickly to adopt renewable power, with capacity doubling in the last five years; non-fossil fuel generation capacity now accounts for 44% of the total. Public health, energy self-sufficiency and import cost considerations motivated the government’s green energy development policy, which has presented investment opportunities. On social indicators, extreme poverty and infant mortality have shown steady declines in recent decades; notwithstanding, progress is uneven.

From a governance perspective, Prime Minister Modi remains popular in the context of solid growth and innovations like digitalisation, which have positively impacted the lives of many. However, there are concerns on two fronts: a) Prime Minister Modi’s concentration of power, and b) the BJP’s Hindu-centric stance and their handling of Muslim rights. These issues present potential political risks for investors.

Opportunities in Indian fixed income

The economic backdrop in India makes for a compelling investment opportunity. India’s stockmarket has attracted international attention as one of the top-returning markets over the past 10 years. However, we focus on an up-and-coming corner of the Indian market — public fixed income.

An essential part of the story for fixed income investors is India’s stable, investment-grade credit rating. India achieved investment grade status from Moody’s in 2004 (Baa3), S&P in 2007 (BBB-) and Fitch in 2006 (BBB-). The ratings have hardly changed over this time, though S&P moved to a positive outlook in May 2024.

Foreign investors can access both sovereign and corporate debt markets in India. One interesting market characteristic is that India does not issue foreign currency-denominated sovereign bonds; of the 15 largest developing countries, India is the only one with this distinction.

Instead, the local currency debt market is large and liquid because the Indian government has funded itself in rupees for decades. India has also not sought out foreign capital for government financing; foreign holdings of Indian government bonds are low at about 2.5% of debt outstanding (June 2024).

There have been new developments, in particular JP Morgan’s decision to add India’s government bonds to its mainstream EM local bond index, the GBI-EM Global Diversified. Indian bonds began phasing into the index in June 2024 and will increase to the maximum 10% index weight by April 2025.

Positive prospects

India provides interesting opportunities from several angles, ranging from the economic to the geopolitical. We are comfortable with the macroeconomic framework and see government policy supporting the private sector in the medium term. In turn, growth should remain strong in the next several years. It is noteworthy that the question is not whether growth will slow, but how much growth could accelerate if everything comes together, including a continuation of the reform agenda.

On the geopolitical front, India’s increasing importance is already evident in company decisions to diversify supply chains to hedge against potential China risk, as well as deeper strategic partnerships with countries like Saudi Arabia and the UAE. Given the trends in place, it is easy to imagine that India’s prominence on the global stage will continue to rise.

Nitin Bajaj, portfolio manager of the Fidelity Asian Values investment trust, has recently been drawn back to a previous investment, Chinese hot pot condiment company Yihai International.

While Yihai acts like a growth company, it currently trades on a value multiple. Why? “Everyone hates China,” Bajaj said.

Yihai International is the sister company of Haidilao, a hot pot restaurant chain known for providing an experience along with a meal. As restaurant goers await their dinner, they are greeted with entertainment, including shoe shines, hand massages and giant stuffed animals. But where Yihai plays its role is within the heart of the restaurant, the meal, providing the soup flavouring.

“Hot pot is all driven by the soup. Yihai makes the soup flavouring for Haidilao, but then takes the Haidilao brand and sells it in supermarkets as well, so you can make your soup flavouring at home. That’s their base business, and that’s how they grew,” Bajaj said.

“Over time, they’ve added other Chinese-style condiments, so not only hot pot, but also soy sauce and different kinds of seasonings. They have a ready-to-eat business as well that comes pre-packaged. You just have to put it in hot water and it’s ready to go. They basically ride the Haidilao brand.”

Bajaj was first introduced to the company over five years ago, when the stock was selling for HK$5 (£0.48) per share. He watched the stock grow in his portfolio to HK$25 before selling out. Then, it shot up to over HK$140.

“It went from 8x to 100x earnings. And then, as with all these growth stories, you make up a fantastic story, you take the stock price up and the story generally never matches up with reality. The stock then collapsed as China collapsed. It is now back at 10x.”

Following the stock’s tumble in 2021, the share price for Yihai International has started to even out. And in the past year, the stock has ticked up by 13.6%, as of 26 September. In the first half of the year, sales for the company grew by 10%, and offers 80-90% of profits back to investors as dividends.

And Bajaj believes more growth is on the horizon as the company expands into a new market, selling to small restaurants. In this model Yihai designs the recipes for the restaurants, and then sells the flavouring needed to create them.

“I know I’m buying a good business that is selling a product the customer wants, at a price the customer is delighted to pay. And by selling at that price, they can make a lot of money. This business has a brand which is really powerful, and it’s going to be around for a long while,” Bajaj said.

“My answer to any stock is always that I have no idea when it will go up, why it will go up, or if it will go up. What I know is I’m buying a good business, and I’m very happy to own it for the next decade.”

Views expressed correct as of 9 September 2024

Animal magic for private equity trust

While private assets have been the on-trend investment strategy this year, the market is hardly new to all. For the Columbia Threadneedle Private Equity Trust, it’s a relationship that spans more than 20 years, since it was founded in 2001.

The trust, run by managing director and head of private equity Hamish Mair, invests just over half of the portfolio in other private equity funds, and the rest in the co-investment portfolio, which invests directly into private companies. The same rationale applies across both types of investments, said Mair.

“It’s a very broad, inefficient market where skilled and diligent investors can find companies at good prices which are growing rapidly and therefore can make good returns,” Mair added.

The trust is able to separate itself from the pack through its investment strategy with private equity funds.

While most managers wait for private equity firms to become well established before investing, Mair is willing to take a chance on “emerging managers”.

“We’re not backing novices. These are not people that haven’t done private equity. Every single one of them will have a track record and evidence of their capabilities. If somebody comes to us and they’re a former investment banker and they have an industrialist friend, and they say, ‘Back us in a private equity fund’, we will say,

‘Thanks, but no thanks. I’m not gambling my client’s money on the possibility that you might be able to transfer those skills to private equity success’”, Mair said.

“Normally, the groups we’re backing have experienced individuals who will have a track record in their previous house. There may have been a spin-out of a bigger organisation, such as an institution or a larger private equity firm, or they may have come from different firms brought together through acquisition. So we have to do a lot of research on them.”

These firms have included Inflexion, a UK-based private equity company, and Chequers Capital, based in France.

On the company side, the trust completed a position this April in Jollyes, a pet supplies and food store it invested in back in 2018. The opportunity was brought to them through London-based private equity firm Kester Capital.

“It had originally been a traditional family company. It dates back to 1935 and was a provider of fodder for horses, when horse and carts were still prevalent in the pre-war period. And then it diversified and became more of a classical chain of pet shop”, Mair said.

The business was the second-largest pet retailer in the UK behind Pets at Home, boasting 60 stores about six years ago.

“The analysis Kester did suggested there was room to make it significantly stronger, and that’s exactly what they did. They doubled the number of stores, they more than doubled the profitability and the staff numbers, and then they sold it.”

Bolstered by a surge in the amount of pet owners during the pandemic, the position was sold at a near 4x return, with the trust ending with a 29% internal rate of return across the six-year period.

“You look back at these investments and you think, ‘Well, that all looks splendid’. It doesn’t necessarily feel like that at the time. There are bumps in the road, and that’s not untypical for a private equity deal. The great thing about private equity is when problems are there, because the private equity house and its backers control the business, they can make changes. They don’t sit around making recommendations. They can actually direct changes take place.”

Playing the healthcare boon in EM

There are ways investors can benefit from the burgeoning healthcare sector across developing nations, without having to undergo the “challenging” research and development process that drug companies have to endure, according to Aubrey Capital Management’s Mark Martyrossian.

The director and head of distribution said the Covid pandemic shone a light on healthcare sector deficiencies across the globe, with emerging markets proving no exception.

“With the proportion of over-65s in EM predicted to increase by over 2.5% per annum [on a rolling basis] – more than double the rate which will be experienced in the developed world – these governments realise the youth factor will fade,” he said. “As a result, several governments, Indonesia for example, have responded by rolling out schemes for healthcare insurance to look after their growing, and ageing, populations.”

Increasing funding from governments therefore means there are compelling pockets of opportunity in the market.

But while “a big slice of the index is accounted for by drug companies”, Martyrossian believes there are better ways to invest in the healthcare space while avoiding R&D pipelines.

“Bed density is still very low in EM, ranging from 40 per 10,000 head of population in China to just mid-teens in India. This is clearly an opportunity for the private sector,” he explained. “We have had investments in Bumrungrad Hospital in Thailand which has the added advantage of being a beneficiary of medical tourism, particularly from the Middle East.

“Tourism is a major contributor to the Thai economy. It is estimated that 1% of Thai GDP is generated by medical tourism, of which Bumrungrad has been a major beneficiary. To capitalise on this theme, the company intends to build another hospital in the tourist hotspot of Phuket.”

The distribution head said the picture is similar in India, where medical treatment is the driver of some 7% of all tourism. “Is it any wonder, given a new knee in India comes at a fraction of the price as the same knee in the US – $7,000 (£5,275.38) versus $50,000?

“Apollo Hospitals is a pioneer in the corporate, private sector hospital segment in India and operates one of the largest hospital networks in Asia, with 73 sites across India.”

Elsewhere, Martyrossian said pharmacies also play a part in the increasing demand for medicines in emerging markets. He is positive on the prospects of RaiaDrogasil, for example, which is the largest drugstore retailer in Brazil with more than 2,500 stores.

“The company has a 15% market share and its size allows it to gain market share from independent retailers through its ability to offer bigger discounts, loyalty programmes and personalised health programmes,” the distribution head reasoned.

“There are just under 100 healthcare stocks in the EM consumer universe. We track 20 of these on our watchlist and believe it will be an ongoing theme for the Aubrey GEM strategy.”

This article first appeared in the October issue of Portfolio Adviser magazine

The purchase, which is subject to approval, will provide “additional scale” to the firm’s emerging markets arm and comes as part of a wider review of Jupiter’s EM franchise.

The move will also see Nick Payne (pictured), lead investment manager for global emerging market equities, leave the company at the end of the year “to pursue other opportunities”.

See also: Jupiter Ecology fund to take on ‘sustainability focus’ SDR label

Origin, which comprises five investment professionals, will also provide Jupiter with access to an international ex-UK portfolio and a global smaller companies fund, two further areas which Jupiter said are “areas of identified demand that broaden the firm’s ability to appeal to a wider range of clients”.

The investment team adopts a quantitative screening approach to portfolio construction, combining algorithms and data with qualitative stock selection. All three of its funds – including its global emerging markets portfolio – have outperformed their respective benchmarks over long and short-term time horizons, according to Jupiter.

Kiran Nandra, head of equities at Jupiter Asset Management, said: “I believe the addition of the Origin team provides a compelling option for clients of both firms on Jupiter’s platform as we seek to broaden our offering.

See also: Whitmore’s former fund to be renamed ‘Jupiter UK Dynamic Equity’ under Savvides

“In addition to bolstering our global equities range and giving us a new global smaller companies capability, the acquisition is an important part of our efforts to increase scale across our emerging markets capabilities as we look to build truly differentiated investment propositions.”

Tarlock Randhawa, managing partner of Origin, said the group is “excited to be part of the Jupiter team, whose “truly active and differentiated investment management philosophy and culture aligns with [Origin’s]”.

“The transition for our existing clients will be seamless and, indeed, we believe they stand to benefit from Jupiter’s focus on excellence in client experience. As well as the benefits to existing clients, we will be well-placed to grow our client and asset base over time.”

Emerging markets have been criticised over the past decade. Dollar strengthening, falling commodity prices, and weak corporate income growth were major reasons for it.

This has led to disappointing returns from investing in emerging markets compared to investments in large-cap stocks. As the global economic situation has changed and become more volatile, approaches to investing in emerging markets have also evolved. 

However, emerging markets still have great potential. The upcoming updates on Fed rate cuts and a possible rise in commodity prices give new perspectives. So, the situation for the markets may have a chance for a positive turnaround.

This raises an important question: Should investors reconsider emerging markets? Let’s break it down.

From BRICS to new leaders

Before, countries from the BRICS group, namely Brazil, Russia, India, China, and South Africa, were most popular among investors in emerging markets. These alliance members attracted the majority of funds flowing to developing countries.

Nevertheless, the situation has undergone some changes. For example, naming China, the second largest economy in the world, an emerging market is not quite appropriate anymore. 

See also: Macro matters: Why managers are buying China again

As for now, other regions are considered more appealing for investors. We can look at emerging markets such as Mexico, Brazil, Saudi Arabia, and Eastern European countries such as Poland. India is also a newcomer to the emerging markets group worth highlighting.

India has experienced a unique rapid economic development. Over recent years, it has become a global financial powerhouse, attracting millions of investors. The main reason for this interest is the country’s skilled workforce, strategic location, and active engagement in international trade.

By 2050, India is projected to become the second-largest economy in the world. So I think it is no surprise that people find the country appealing as an emerging market. 

Consider each region independently

As new markets enter the global arena, so approaches to investing in developing countries change. A BRICS-centered portfolio used to be a source for stable returns, but now investors better not rely on considering countries altogether, since the differences among countries have grown dramatically. 

The wisest approach would be to evaluate every country or region independently. And what will be even better is to examine emerging markets after dividing them into regions—not Brazil and Poland, but Latin America and Eastern Europe.

Such separation can help avoid risks connected with regions’ unique features; for example, the Latin American market lacks the ability to make long-term forecasts. The political systems in countries of the region are so unpredictable that you cannot know for sure what to expect. 

Balancing prospects and risks

Even though emerging markets have experienced some sort of disappointments, investing in them still offers more benefits rather than drawbacks. 

They offers higher returns, especially compared to investment opportunities in the US or European countries. But remember about the flipside – higher returns always entail higher risks that investors need to accept. In the case of emerging markets, these risks can be justified due to high returns during low rates. 

See also: Does India deserve its premium to emerging markets?

Another advantage of investing in developing economies is an opportunity to diversify the portfolio. There is a big difference between infusing funds into emerging markets and investments influenced by geopolitics. Investing in developing countries means buying a tangible business.

Buying shares of Indian pharmaceutical companies, for example, opens access to a market of 1.5bn people, which is entirely different from simply buying future Fed’s decisions. 

However, everything comes with several drawbacks. India and Brazil are comparatively hard to enter. You cannot make particular investments or buy individual companies’ shares. To do so, you will have to turn to a professional asset manager or just simply buy an exchange-traded fund.

They already include your potential profits from these markets but are less risky. The variety of them has grown, so it is much easier and more accessible just to choose an appealing one. 

All in all, investing in emerging markets may present more prospects than risks. Future Fed rate cuts will make advantages even more notable, as many investments will become less profitable among low rates.

The recipe to success is understanding each region’s specifics and choosing what you want to invest in. If you want to reduce risks even more, take a closer look at ETFs, which professionals construct to maximize your profits.

One of main appeals of emerging markets debt is the breadth of geographical exposure available to investors.

The asset class has grown significantly in the past two and a half decades. There are 69 countries in JP Morgan’s popular EMBI-Global Diversified index today – when it launched in 1995, there was only eight.

In line with this expansion, there has been a growing number of smaller, high-yield rated issuers that have entered into the index. These ‘frontier economies’ are off the radar versus the more developed markets such as Brazil, Mexico and India.

Shocks and challenges

Emerging markets have confronted multiple shocks since 2020, including the pandemic, the increase in food and energy prices, and higher global interest rates.

For frontiers, which are smaller economies, this has resulted in higher yields and more limited access to dollar-denominated funding.

These global challenges raise the question – why should I invest in frontier economies? We consider three points to be salient.

First, among the 38 countries in the space, there is diversification potential. Second, there is plenty of differentiation among the sovereigns. And last and most important, frontiers have significantly outperformed the broader dollar-pay EM bond indices since inception.

See also: Square Mile: Emerging market debt funds to watch

A comparison between the JP Morgan EMBI-Global Diversified index and the NEXGEM index substantiates this point. During 2023, the NEXGEM index returned 21% – nearly 1,000 basis points better than the EMBI-Global Diversified.

This outperformance continued through the first quarter of 2024, with NEXGEM climbing 5.2% compared to the 2% return from the EMBI-Global Diversified index. 

Concerns and defaults

After the shocks following the pandemic period, some clients asked whether investing in frontier markets was too risky. We put some perspective on this issue.

Together, the seven frontier markets that defaulted on external index-eligible debt since 2020 account for just 1.4% of EM GDP.

Likewise, many of the weakest countries have already entered into payment difficulty and many of the weakest hands have folded. Our view is that the default cycle has played out.

With many investors drawing a similar conclusion, there was a strong rally in frontier sovereign debt in 2023. Many frontiers were expected to face payment stress over the period, but when this did not occur, they outperformed.

The other group of countries are those that already defaulted. The investment thesis is that these sovereigns are prepared to settle with their creditors on terms better than initially feared.

This highlights another relevant point – for most countries, the relationship with their creditors does not end after a restructuring. Countries typically renegotiate the terms of their debt and continue to engage with creditors as they restructure.

Diversification

Frontier debt investing allows for exposure to countries that cannot easily be found in other asset classes. This is not limited to dollar-denominated debt, as investing in frontier local markets also presents dynamic opportunities. Because frontier markets are smaller, they tend to be driven more by internal market dynamics.

This has two implications. First, local currencies in these economies are less correlated with other EM currency markets.

Similarly, these markets are not as saturated by international investors, so macro considerations in these markets can be more important than global drivers. Although, the potential for higher returns in such markets can come at a cost of less liquidity.

See also: Are emerging markets back on the menu?

How do we put this into practice? In the early months of 2024, we added local frontier exposure in markets such as Nigeria and Egypt.

From a top down perspective, these new additions come in a context in which global growth is supportive and multilateral support has been strong for EMs.

Looking from the bottom up, the medium-term debt outlook has shifted more favourably in these economies over the past day.

In Egypt, for example, it was due to significant external support from the Middle East and the IMF that was announced in February 2024.  

Selection matters

It is clear that frontier economies have delivered superior returns compared to the broader EM universe since inception, but these greater return often come with greater risk. How should investors evaluate this risk-return puzzle?

Country selection is key. Investors need to evaluate whether country fundamentals are improving or deteriorating. This has translated in our portfolios to an overweight position that is concentrated in the countries where we have a positive outlook.

Our active positioning in frontiers has typically been above their share of the benchmark, but where we see a challenging outlook, we will take zero exposure.

See also: Diverging performance: What is driving emerging market returns in 2024?

Now that Modi has entered his third term as prime minister, his next key ambition over the coming five years is to grow India’s manufacturing sector as a share of gross value added (GVA).

Since he first took office in 2014, the manufacturing sector has accounted for just under 20% of GVA. This is despite his party’s ‘Make in India’ initiative which aims to “transform India into a global design and manufacturing hub”.

One of the key pillars of this initiative is the Production-Linked Incentives (PLI) scheme, which was introduced in 2020. The scheme proposes financial incentives with the goal of boosting domestic manufacturing across 14 key sectors.

Its introduction was aligned with the release of an updated foreign direct investment (FDI) policy that aims to improve the ease with which foreign companies can invest in India.

However, the success of these policies is debatable. Although FDI has risen since the initiative was introduced in 2014, it has not risen as a percentage of GDP.

Indeed, most of the flows have not been into sectors that PLIs focus on. They only accounted for 31% of FDI from 2000 to 2013, but their share of FDI dropped to 26% when measured from 2000 up until 2022.

See also: Does India deserve its premium to emerging markets?

There are clear areas for policy improvement in Modi’s next five-year term as prime minister. Import tariffs supposed to encourage local sourcing are reducing competitiveness in global markets.

It is notable, for example, that Vietnam and India accounted for roughly the same share of world mobile phone exports in 2010, yet Vietnam’s share was over four times greater than India’s in 2022.

Over the same period, India’s average tariff on mobile phone parts rose by around a third while Vietnam’s was unchanged, ending 2022 at almost half the level of India’s.

The signing of a free trade agreement (FTA) in March with Iceland, Lichtenstein, Norway and Switzerland represents a step in the right direction. Modi’s aim for India’s manufacturing sector to account for 25% of GVA by 2025 means it is likely that more PLIs are announced over the next year under a fresh push of the ‘Make in India’ initiative.

Accelerating infrastructure and clean energy

In Modi’s 2019 election manifesto, he pledged to construct 60,000km of national highways by 2024 and electrify all railway tracks by 2022. These goals have not been met.

At the end of 2023 there were 146,145km of national highways in India – 49,600km above the level in 2019 – and 94% of railways had been electrified by the start of this year. Despite not achieving the targets, the progress compared to the period before Modi was first elected in 2014 is significant.

Infrastructure development will remain a key area of focus for Modi in his next five-year term. However, it is not a sustainable policy to keep building roads at the same pace and there will be no railway left to electrify. The focus is therefore likely to shift.

One area of focus is likely to be building more electric vehicles (EVs). Electric cars currently have a 2% market share in India, highlighting the potential for growth.

Modi’s government approved a new EV policy in March that reduces import costs for foreign EV producers setting up manufacturing in India.

Narendra Modi’s re-election for a third term as India’s prime minister was confirmed on 4 June. Future policy will continue to focus on boosting the manufacturing sector, with new PLIs possible as part of the ‘Make in India’ initiative. Infrastructure investment with a focus on clean energy is also likely to be a key pillar of the BJP’s policies for the next five years.

One of the themes of Modi’s first two terms in office has been the setting of ambitious targets that are often not achieved. While this may continue, it is important to note that ambitious targets have often brought with them a significant acceleration in progress towards the government’s goals. While it should be acknowledged that there is room for policy improvement, India remains on the right path for a prosperous future.

See also: Three key factors that could ‘change the script’ for Asian equity funds

His party, the Bharatiya Janata Party – which forms the lead partner of the NDA coalition – was unable to maintain its single party majority, however, having won 241 seats compared to the 303 won in 2019.

After hitting an all-time high off the back of strong exit polling in favour of the BJP, the Sensex index of Indian stocks fell 8.24% as the narrower-than-expected result came to light on Tuesday before regaining some ground.

“This reduces the dominance of the BJP and essentially highlights the formation of a weaker alliance government in the offing,” says Gaurav Narain, manager of the India Capital Growth fund.

“While we expect policy continuity, with the Government continuing its investment led economic agenda, it may tweak priorities to support rural consumption and employment.

“A challenge the new government would however face is that it would need support from its coalition partners in decision making. This would constrain it in making bold reforms – particularly in areas of agriculture laws and labor reforms. It may also steer away from contentious issues like implementing a uniform civil code.”

“From a market perspective, we expect a stronger focus towards demand revival in rural India, benefitting consumption stocks. The investment led stocks, particularly the Public Sector Unit (PSU) could see some pull back.”

See also: Does India deserve its premium to emerging markets?

Narain adds that a positive outcome of the election has been that it strengthens India’s democratic credentials. Ahead of the elections, there were allegations that the Modi government was influencing the outcome of the elections, and fears that an even stronger third mandate for the NDA alliance may give it too much power with speculation they would make constitutional amendments, questioning the secular nature of democracy.

Building on this point, Will Scholes, fund manager at Premier Miton Investors, believes a weakened majority is good news from an ESG perspective.

“For all that Indian markets today are signalling alarm, a weaker win for the BJP is good news for India,” he says. “It’s a sign that a centralised growth model will have to de-centralise, that the rapid rise in inequality and the over-used politics of religion must be slowed, and the government will have to tread a more inclusive path going forward. India’s economy has been doing well through a period of turmoil round the world, helped by major digital and physical infrastructure advances.

“But, still the most fundamental reform remains unaddressed: to provide jobs at scale to the bottom of the population pyramid and move people out of agriculture and into employment where they can accumulate skills and savings. For too long the population has been pulled up from the top, not pushed up from the bottom. Today’s vote count offers the perspective that great economic strides forward cannot make up for politics that have become too strident.”

Worst-case scenario avoided

For Abhinav Mehra, portfolio manager at Chikara Investments and co-manager of the Chikara Indian Subcontinent fund, the biggest takeaway from the result is that the perceived market risk of a hung parliament or the spectre of another election is now over.

“While the BJP was unable to reach a majority alone, they still managed a comfortable majority with their core allies which means that we should see a continuity of government and PM Modi. This may have been a political shock, but it bodes well for Indian equities, especially the domestically focused stocks we invest in. Domestic consumption stocks have been the best-performing pocket of the market since the results.

“We believe the new government is likely to counter the narrative that a rural slowdown in UP and Maharashtra hurt their prospects in the election by focusing more intently on ensuring domestic growth and consumption keeps growing. Oil prices back below $80 creates the room for this near-term stimulus boosting consumption and credit growth. This may come at the cost of market areas reliant on aggressive infrastructure roll outs, where we’re likely to see expectations tempered.

“Longer term, we may see an increased volatility in the next 5 years than in the previous term. We believe economic reforms – the most challenging of which, in our view, were implemented in their first term (2014-2019) – will be prioritised, with that the more disruptive socially divisive reforms (i.e. Uniform Civil Code, One Nation One Election) put on the backburner.

“As long as the strong growth rate from the positive capital cycle continues undisrupted, the long-term outlook of Indian equities remains robust – especially compared to so many economies that are highly levered and ageing. Against this backdrop, many would envy India’s fundamentals of more than 8% GDP growth, a clean banking system driving a cyclical uptick in credit and property, stable inflation and a macro environment with pockets of reasonable valuation across the market.”

See also: Square Mile: Emerging market debt funds to watch

Long-term investment case remains intact

Jason Hollands, managing director of Bestinvest, said that despite the narrower-than-expected result, the long-term bull case for India remains intact.

“From an investor perspective, the BJP is business friendly and under Modi’s tenure the country has undergone meaningful, structural reforms as well as making huge strides in modernising its infrastructure. Notable measures have included digital transformation of the welfare system which included implementing the world’s largest biometric ID system, streamlining a patchwork of state taxes into a national Goods & Service tax, flushing out money in the black economy by replacing notes in circulation, liberalising Foreign Direct Investment rules across a number of sectors (including defence, aviation, and retail) and other measures that have much improved India’s competitiveness.”

“With another five years in office likely to be secured, investors will be hoping for a continuation of the drive to modernise India and attract foreign investment under the banner of the government’s ‘Make in India’ initiative,” he adds. “Key themes in the BJP manifesto included extending access to welfare, job creation and further infrastructure investment, an example of which are plans to extend the reach of high-speed bullet trains.

“For private investors, India is simply too big an opportunity to ignore. Over the last decade, it has climbed the global rankings from being the 11th largest economy to fifth place. The International Monetary Fund, estimates India will see real GDP grow by 6.5% this year, outpacing all other major emerging market and advanced economies. Modi’s pledges include expanding India’s GDP to $5trn by 2027, which would make it the world’s third-largest economy.

“India has certainly been a bright spot amid a tough period in recent years for emerging market equities which have been dragged down by the ugly performance of Chinese shares since early 2020.”

The upbeat note on which emerging market debt entered the year continues to prevail. But while tailwinds exist, there are a myriad of potential risks to navigate in the coming months.

Improving prospects for global economic growth, coupled with the Federal Reserve likely being at or near peak rates, have buoyed sentiment across EM debt.

Spreads continue to grind tighter across sovereigns and corporates and while the aforementioned factors are certainly reasons for optimism, the significant tightening in spreads is also evident among weaker EM regions and credits.

This widespread rally, when viewed in the context of what appears to be a challenging last mile in the global battle against inflation, ongoing wars in Europe and the Middle East, and elevated political uncertainty around the world, begs the question – are markets getting ahead of themselves?

A supportive backdrop, but persistent risks

With the US economy growing, China’s weakness appearing to have found a bottom, and the rest of Asia continuing to gain strength, sovereign hard currency debt remains on solid fundamental footing as recession concerns ebb.

In particular, the strength of the US economy benefits countries in South and Central America and the Caribbean given the multiple linkages between them from trade to tourism.

The technical picture also remains supportive for EM debt, with institutional investment flows in EM turning positive in 2023 following a year of outflows. Outflows were dominated by retail funds last year, but developed market commercial banks increased their exposure to the asset class. Historically, smart money inflows have been a leading indicator of overall investor inflows into EM debt.

However, the overall picture is also one of a number of potentially significant risks. There is the possibility for further escalation in the Russia-Ukraine war – which could have a contagion effect on neighbouring countries – as well as elevated political risk given the number of elections around the world this year.

On the positive side, many EM election outcomes are priced into the market and therefore unlikely to result in any major disruptions. Perhaps counterintuitively, the US presidential election may be the one most likely to introduce volatility to the EM market – if Donald Trump returns to office, a number of major international policies could be called into question.  

In this environment, we see value in investment grade (IG) sovereigns with solid fundamentals, particularly in BBB countries such as Mexico, Uruguay, Bahamas, and Indonesia.

Select opportunities also remain in the high yield space, especially where spreads continue to offer a healthy overcompensation for default risk. Specifically, we see value in high-quality BB sovereigns such as Dominican Republic, Costa Rica, Jamaica, Paraguay, and parts of Eastern European.

In the local debt space, we are less constructive on local interest rates because we expect to see fewer and smaller cuts from EM central banks going forward. However, there are a few EM countries that still have room to cut, such as Mexico and some Central and Eastern European nations.

The growing opportunities in IG and select HY

Spreads in the EM corporate market continue to tighten in tandem with other markets and are approaching post-crisis tights. However, absolute yield levels look attractive relative to many other fixed income asset classes.

While there are potential significant risks on the horizon that could derail this tightening and drive spreads wider — which provides a reason to advocate for some degree of defensiveness — we also see tailwinds supporting the market.

In particular, funds are being reallocated from money market funds into developed market investment grade (IG) asset classes, which is providing crossover demand tailwinds for select segments of EM corporates.

Specifically, we see EM IG corporates (which constitute roughly 60% of the EM corporate debt universe) as the segment that is not only benefitting from demand tailwinds, but is also likely to benefit from potentially attractive convexity when the Fed starts to cut rates.

We also see value in select idiosyncratic opportunities in the high yield space, as the segment is likely to benefit if economic data continues to point toward a ‘no landing’ scenario and sentiment improves for riskier debt. In addition, corporate fundamentals overall remain sound for both IG and HY companies.

From a sector perspective, we remain cautious around sectors which have been impacted by the lower cost product exports from China such as petrochemicals and steel.

We also see some technology, media, and telecommunications companies challenged with the aftermath of higher funding costs, the capital expenditure overhang from previous years, and a reduced ability to pass through costs to consumers.

A cloudy crystal ball

While current conditions remain favorable for EM debt overall, the potential for disruption exists across many fronts – and either political or geopolitical events could pose risks for EM assets going forward.

Despite the riskier backdrop, we believe the diversity within EM sovereign, corporate and local debt provides a breadth of opportunities across issuers and regions which have unique performance drivers.

In our view, rigorous, bottom-up credit and country selection, combined with active and discriminating management, remain paramount to managing the risks across the market, as well as to identifying the issuers that are well-positioned to navigate the uncertain environment.

The external environment affecting emerging markets (EM) has materially changed in recent years, with slowing global growth and tightening financial conditions creating a more challenging backdrop.

For some, this only confirms the perception of EM as a purely short-term, tactical allocation – offering potentially high returns, but at a cost of heightened risk and volatility.

However, this view of EM not only underappreciates the sheer scope of investment opportunities, but also fails to understand how significantly the EM universe has evolved in recent decades.

Avoid EM as growth slows

The playbook for investing in EM has changed, with decisions no longer predominantly driven by the global economic cycle. Today’s EM landscape demands a more granular approach and country-by-country expertise, as broad EM generalisations have become increasingly tenuous.

In addition to differences by country, EM offers a varied menu of assets to invest in, including hard currency sovereign and corporate debt and local currency debt, as well as deeper, more mature, equity markets.

Recent developed market (DM) policy tightening has been felt disproportionately across EM debt markets. On one side is a group including Mexico and the larger economies in South America that are underpinned by robust fundamentals. This group continues to be able to access credit markets, and spreads have remained reasonable and relatively stable.

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On the other side is a set of fundamentally weaker EM countries that are struggling to refinance debt nearing maturity, and many have either defaulted already or are at risk of doing so.

In regards to equities, the EM universe is split along similar fundamental lines. However, through detailed research and a good understanding of regional and country-specific dynamics, it is possible to find fundamentally good businesses at potentially distressed prices.

EM offers few defensive qualities

One of the biggest investor misconceptions is that EM is all about dynamic, growth-oriented companies. Asset flows confirm this perception, with data showing that the bulk of all active money flowing into the EM equity universe is invested in growth strategies, while only a fraction of total flows are invested in value.

This huge bias means that a lot of value-oriented opportunities, particularly in traditional ‘old economy’ areas like manufacturing, are being overlooked. Consequently, many good businesses are flying under the radar at potentially very depressed prices.

Companies with relatively low-risk profiles, reasonable P/E levels, and predictable earnings streams may not fit the traditional view of a ‘dynamic’ EM investment, but these businesses exist.

Risk of policy and company error is greater in EM

Significant reform measures have been implemented in many EM countries, meaning most are no longer just a few bad decisions away from a crisis.

Detailed research is central in identifying those countries that are truly committed to consistent, market-friendly policy direction. Similarly on the corporate side, great strides have been made in terms of improving governance.

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Even when sharp sell-offs do occur in EM debt markets, we no longer fear that these events pose a systemic risk to the wider asset class. Over the past 25 years, when such periods have occurred, they have proved relatively short-lived, creating opportunities to enter the market at potentially depressed valuations.

On the equity side, evidence of stronger management discipline and better decision-making is a key factor, suggesting a positive longer-term outlook for EM equities.

EM growth potential to be subdued

While market uncertainty and a mixed global economic outlook are important influences on the broad EM outlook, these need to be weighed against the strengths of individual economies and the positive secular trends that continue to support long-term optimism in EM generally.

For example, many EM countries continue to enjoy positive economic growth at rates well ahead of DM. Internal trade between EM economies has now surpassed external trade volumes with DM economies, while a growing EM middle class is supportive of long-term domestic demand.

While EM still has a lot of room to potentially improve productivity and catch up with DM peers. Large, young, and increasingly educated workforces are central to closing this gap, along with the broadening adoption of technology.

ESG considerations in EM significantly lag DM

While ESG investing has entered the mainstream in DM, there is an ongoing perception that less importance is attached to these factors in EM.

However, EM companies have made great progress in improving ESG credentials in recent years, with many businesses today displaying standards in line with global best practices.

Issuance of sustainable bonds in EM has also noticeably increased in recent years, driven by robust issuance from some relatively new participants – including the Philippines, Mexico, Colombia, and Chile. This adds to the prominent issuance in more seasoned markets, like China.

It is also worth highlighting the huge investment made by China in recent years in transitioning from fossil fuels. China is now the world’s largest producer of wind and solar energy and also the largest domestic and outbound investor in renewable energy.

This seismic shift is creating knock-on benefits for EM countries and companies geared to this transition, as well as having positive implications for energy security and affordability across the EM region.

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Due to the logistics of holding a democratic vote for 968 million eligible voters, the process is spread out over six weeks, meaning official confirmation of the result and vote share won’t come until after the final ballots are placed on 1 June.

While the population will have to wait for the official result, the incumbent Bharatiya Janata Party (BJP), led by prime minister Narendra Modi, is widely expected to secure a comfortable victory.

If re-elected for a third term, Modi has pledged to make India the world’s third largest economy by 2027. So what should foreign investors be looking out for ahead of the election?

Vote share

With most commentators and polls predicting a victory for Modi and BJP, fund managers invested in the region believe the main risk around the election from an investment perspective is around the size of the majority the party may win.

Gaurav Narain, portfolio adviser of the India Capital Growth Fund says: “The Modi-led BJP is expected to win. The main question is how strong would the mandate be? In the previous election in 2019, the BJP won 303 of 543 seats. Their target in this election is 370 seats.

“The closer they reach to 370 the more positively it would be viewed. As the expectation of a BJP victory is already factored in, we see no material impact on the markets or the fund. If the BJP however fares poorly, or does not get a majority, it would be negative for the markets and the fund.”

Chetan Sehgal, lead portfolio manager of the £1.7bn Templeton Emerging Markets Investment Trust (TEMIT) adds: “The vote share matters a lot, because in India some of the seats can swing by a small number of votes. Therefore, typically, the index of opposition unity actually matters in deciding elections. But this time around, even though the opposition seems to be more united, the chances are still in stacked in favour of the BJP.”

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Economic policy

Investors will also take note of any potential change in economic policy, which may have implications for markets. Should the BJP win a third term, however, many believe the government will continue on a similar course of conservative fiscal policy.

TEMIT’s Sehgal notes that it is likely that the focus on conservative fiscal policies will persist. “A two-thirds majority of votes for the BJP and its coalition partners would empower prime minister Modi to make constitutional changes, addressing critical concerns among local businesses and foreign investors. Additionally, there is potential for judicial and economic reforms that could enhance the government’s capacity to generate additional tax revenue.

“Prime minister Modi has dubbed the 2020s as India’s ‘Techade.’ In the short term, he aims to boost domestic demand, while the medium-term focus lies in enhancing export capacity. Negotiations for free trade agreements are underway with the European Union and the United Kingdom. Additionally, the India-Middle East-Europe trade corridor is being developed to leverage tariff-free access to these markets.

“These supply-side policies are equally critical alongside investments in manufacturing capacity, as they contribute to building a sustainable long-term export base in India. Recently, policymakers have emphasized investment in semiconductors to diversify the technology sector’s reliance beyond software services.

“India offers investors a significant growth opportunity given its structural tailwinds, which include attractive demographics, a market-oriented economy, and a rising middle class. These robust growth prospects are, however, reflected in valuations of many securities, which trade at a premium to other emerging markets. We remain selective in companies we invest in and favour companies which have sustainable earnings power and whose share prices are at a discount to our estimate of their intrinsic worth.”

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India Capital Growth’s Narain adds: “The possible impact of the election outcome on industries lies in the government’s approach to economic policies. The current government has focused on streamlining policies, such as implementing the Goods and Services Tax (GST), which simplifies taxation across the country.

“It is a very transparent policy environment today, reducing the role of politicians in manipulating taxes and promoting a more stable and predictable investment environment. In the past few months, Modi’s been travelling the country every day visiting various cities and inaugurating projects worth billions of dollars – he’s a busy man and his plans for India don’t seem to be slowing down anytime soon. “

“There are a few areas where the current government hasn’t made huge inroads and those will be the next topics of focus post-elections. The Indian legal system, though independent, is very slow, with judgments potentially taking 5-10 years. It is expected that moves will be made to streamline the legal system so that businesses no longer move out of India for arbitration.

“In the labour sector, whilst labour is a state subject, Modi’s whole agenda revolves around his aim for India to be a developed country by 2047, so he needs the per capita income to move up. It is highly likely that there will be a more concerted push for India to become a big manufacturing base.”

Sustainability

In terms of sustainability, Will Scholes, manager of the Premier Miton Emerging Markets Sustainable fund, says he is looking for signals on anything to improve education and health outcomes.

Meanwhile, he also hopes to see support for manufacturing jobs to move people out of agricultural employment, as opposed to the government providing subsidies to farmers.

“That is probably the part of the economy that most worries us,” he says. “India’s successes economically have come with a marked increase in inequality, where the top 1% now have a sufficiently high proportion of total earnings. On that measure, it’s even more unequal than the US. So we’re looking for things that help to address that, and in particular the need for more low end manufacturing jobs.

“The final point is on the inclusion of women. Female participation rates in the workforce are far below the rest of the emerging world. And that’s a drag both for the economy and also for savings rates. Because if you have more women in the workforce, by and large, you do save more. And that’s not just because you’ve got another person in the family unit that’s working, it’s also because you can have fewer children.

“Those are all quite long-cycle policies. I take as read the urban infrastructure reforms, such as water reforms, I’m sure they will still push ahead with that. You don’t need to go to India to see the need for better public transport systems in particular, and urban planning, but I think that in terms of their their intention to become a developed economy that’s taken as read.”

TEMIT’s Sehgal adds: “Efforts are needed to improve female participation in the workforce, upskill workers to facilitate a smoother transition to new employment opportunities, and encourage greater youth engagement.

“Enhancing skills and productivity is essential for India to harness the benefits of its sizable and youthful population.”

Between December 2023 and the end of March this year, investors added a net £6.69bn to the sector compared to £6.38bn for the previous nine years combined. In March alone, North American funds attracted £1.77bn.

Equities as a whole attracted a net £2.3bn in March, ensuring Q1 2024 was a record for equity fund inflows, totalling £6.97bn since January.

Global equity funds also proved popular, both in March and in Q1 as a whole, with net inflows of £1.22bn and £3.3bn respectively.

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By region, only Asia-Pacific and UK equity funds recorded outflows.

Despite the FTSE 100 reaching its highest point this year in March, it was the 34^th consecutive month of net outflows for the UK. The net £823m sell-off was the worst month for flows since February 2023.

Edward Glyn, head of global markets at Calastone said: “UK equities are certainly cheap, but investors worry where the growth is going to come from to drive earnings higher.

“Add a relentless narrative of gloom about the prospects for the London stock market and it’s hard to persuade anyone to hold UK-focused funds. Meanwhile the US earnings recession is over – profits are once again on the up and that seems to be the main catalyst driving fund inflows and higher share prices.”

Elsewhere, there was also increased demand for emerging market products, with investors placing £362m in the asset class in March.

Country-specific funds also enjoyed inflows, particularly those investing in India, Japan and South Korea, while China funds suffered outflows.

ESG equity strategies also continued to see net inflows, with £691m net new cash arriving in March.

Among other asset classes, £460m flowed into fixed income funds, rising to their highest level since June 2023. Meanwhile, outflows continued for mixed asset funds and property funds.

Glyn added: “Bond markets have had a rough start to 2024 as hopes for rate cuts were pushed further out into the future.

“Yields have risen to levels last seen in November, which pushes prices lower. and are proving increasingly attractive to investors keen to lock into relatively high levels of income and who believe there is the prospect of capital gains to come when rates fall.”

The year of the Dragon has started with investors split between those abandoning Chinese equities and those seeing contrarian opportunities.

This sums up the key questions facing investors after a three-year bear market in the world’s second largest economy – will the future be like the past? And is China simply uninvestible because of its political regime?

Let’s start with the first of these questions – the outlook.

Hero to zero

Here, the challenge is to set aside behavioural biases and construct realistic potential outcomes based on the data, then estimate how much weight to put on each scenario. This starts by recognising that our behavioural instinct is to give way too much importance to recent experiences – in this case disappointment – when thinking about what could happen.

The evidence from our Morningstar flows data is that these biases lead investors to make bad timing decisions that detract value. In our latest ‘mind the gap’ study, returns were lower when flows were taken into account versus the underlying fund return.

To put the facts about China today into perspective, we need to look back at the last 3 years.  In early 2021, China was a market darling and clocking up two years of high returns.  IMF studies show the dramatic rise in the number and value of listed Chinese companies. By the end of 2020, China comprised approximately 40% of Global Emerging Market indices and foreign ownership at between 3.5% to 4% – both historic peak levels.

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Investors overlooked many of today’s concerns that were evident back then: residential property overbuilding, US trade restrictions, high debt levels, and periodic pendulum swings in government policy from reigning in the private sector, to supporting its growth.

Since then, economic growth has disappointed, impacted by stringent COVID lockdowns, the drop in inbound investment, and the fall-out from the residential property boom and bust. Corporate profits were also hit by the “common prosperity” regulatory crackdown in late 2021 that added severe restrictions on gaming companies and private education companies, and sanctioned high profile powerful corporate executives. Foreign investors swung from bulls in 2021 to bears by 2023, dramatically scaling back their exposure.

A changing future

So where has three years of a bear market left us today? Well, here are five current facts that paint a very different picture from when the market peaked.

First, profit margins are at the low end of their historic range and rising.  Second, valuation measures are at the low end of their historic ranges too. Third, measures of sentiment point toward pessimism, including profits expectations, net flows and positioning. Fourth, government micro economic and macroeconomic policies have eased to be more supportive of the economy and companies in general, including gaming.  Fifth, the market composition has changed.

Many major companies are dominant franchises with low levels of debt, while the banking sector and property development sectors are much smaller parts of the market than in the past. 

These five factors tell us that China is a pariah market, one that has priced in greater risks, weaker growth and discounted any eventual cyclical recovery. These are typically the hallmarks of a good investment opportunity.

By comparison most other equity markets are trading at levels at or above fair value, and there are increasing signs of extreme optimism in several leading US stock market companies.

Is authoritarianism a concern?

That still leaves the issue of how much to allocate to an increasingly totalitarian, communist state. Sizing exposure comes down to both the margin of safety embedded in current share prices, as well the degree of uncertainty – in other words randomness that makes it virtually impossible to estimate probabilities.

China’s most striking difference is its one-party state, which under Xi Jinping has taken a greater degree of control over everything, including more entrepreneurial listed companies.

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For this reason, we believe fair value is lower vs comparable assets in countries which do have independent rule of law, strong shareholder rights, and greater predictability and transparency of government regulation.

It is also why portfolio exposure should be considerably lower, even when opportunities are brightest. We thus constrain our direct exposure to China and hold less than we would for many other large markets that are similarly attractive. 

Should China exposure be zero?

Well, around the world all governments have become far more interventionist.  Covid ushered in much larger government spending and regulation. Policies to reduce emissions and incentivise onshoring, such as the US’ Inflation Reduction Act and Chips and Science Act, have had huge impacts on businesses, as does the rise in military spending.

In other words, no matter which equity market you invest in, the fate of companies is heavily influenced by governments via fiscal policy, monetary policy, regulation, trade, the military and direct government investment. A productive and active private sector is recognised as playing a key role in supporting political stability via employment and the shift to high productivity industries, where the private sector has been the key driver.

So, we do not see a convincing case for excluding Chinese equities from a well-diversified portfolio, given the quality of leading listed private companies and their strategic importance for China.

The real problem has been that investors closed their eyes to all the known risks and invested too much at peak prices. The painful ride has taken its toll, but today these risks are priced-in and an appropriately sized exposure is warranted.

In fact, our own research shows that prospective risk adjusted returns are higher than usual in absolute terms and vs other markets, so we hold more than usual in our Morningstar multi asset funds and managed portfolios.

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