For those investors who believe in mean reversion and the cyclical nature of capitalism, it is reassuring that sectors and companies do not to retain market leadership for long. However, because of momentum and recency bias, investors always extrapolate the present into the future. So, we see today’s near unanimous agreement that the current crop of great U.S. companies – the tech behemoths – will rule forever, expanding their reach into every nook and cranny of the economy. Until recently, this also seemed obvious in emerging Markets
Just to be contrarian, I’ve argued that, given how utterly unpredictable the future is, new leadership would somehow take over in emerging markets during the 2020s. Given that the past decade belonged to China, and the one before that was all about commodity producers, perhaps India could now have its “roaring” 20s.
The table below shows the ten largest stocks in the MCI Emerging Markets index since its early days, 30 years ago. We can see that every decade was marked by an exceptional trend: 1990, the great Taiwan stock bubble; 2000, the technology-media-telecom frenzy; 2010, the commodity super-cycle; and 2020, the rise of China and its “invincible” tech giants. Well, now it seems China’s tech leaders may have been more Goliaths than behemoths, as they are being taken down by government regulators who, unlike their U.S. counterparts, have the power to dictate rules to these firms in accordance with their notion of what serves “common prosperity.” China, which had 7 stocks in the top ten at year-end 2020 (including Naspers), now has five; and India has increased its count to two. If we look at the next ten stocks in the following table, we get an even better idea of the change in the investment environment: China had half of these stocks at year-end 2020 and now only two; India had two and now has three. Also joining the list are two more commodity/reflation stocks, Gazprom and Sberbank, both from Russia.
The changes this year in the rankings of the most prominent stocks in EM has resulted from the outperformance of Indian stocks relative to Chinese stocks, as shown in the table below. Year-to-date, Chinese stocks have lost 16% of their value while Indian stocks have appreciated by 27%. Consequently, the weight of China in MSCI EM has fallen from 40% to 35%, while India has risen from 9% to 12%.
So, what is causing the rise of Indian stocks and can this be sustained?
India’s current advantages over China can be resumed as follows: much better demographics, much less debt and relatively greater support for private enterprise over the state sector. Also, India’s GDP is expected to grow much faster than China’s. Moreover, while exports and urbanization (infrastructure/real estate) are mostly tapped out as sources of growth for China, India has long runways in both these areas. Finally, India’s blue chip corporations generally wield significant political power and are unlikely to face the regulatory risks faced by Chinese companies. To the contrary, India is likely to promote national champions in frontier tech industries, limiting the reach of the American tech giants.
Unfortunately, investors may have already priced in India’s growth opportunity to a considerable extent. Though, in a world of scarce growth and record-low interest rates, Indian blue chips with good growth profiles should be expected to trade at high valuations, Indian stocks now trade at record levels and sky-high valuations. The chart below shows PE and CAPE ratios for MSCI India, with consensus earnings for 2021. CAPE ratios are nearing the “bubble” levels of 2010.
The following chart shows historical earnings. It includes the 2021 consensus which appears very optimistic relative to the current condition of the economy and business confidence. We can see in the next chart from Variant Perception that there is currently a severe and unusual disconnect between the level of stock prices and business confidence.
The future path of the market will be determined by how this divergence between stock prices and business confidence is decided.
For the market to make further progress from here, India, like almost all non-U.S. stock markets, needs to break out from a long period of earnings stagnation. We can see in the following chart that India over the past four decades has undergone several long periods of earnings stagnation which were followed by sudden bursts of profitability.
We can see in the final chart that the market is now anticipating another earning surge. The market has risen well ahead of GDP and earnings (consensus 2021). Of course, this optimism needs to be confirmed. To a considerable degree, this will depend on global developments: basically, a weakening of the USD and a shift away from risk aversion and liquidity preference to higher risk opportunities outside the United States. If earnings can really break out in India, then, it’s off to the races.
