Modi premium for Indian stocks gets a hard look after elections

In recent years, investors bullish on Indian equities have cited the promise of policy reforms and rapid economic growth under Prime Minister Narendra Modi to justify its record premium over emerging-market peers.

Now, with the leader facing coalition politics after a weaker-than-expected mandate in this week’s national election, the so-called Modi premium is under scrutiny. Investors want to see evidence that Modi can sustain his reforms with the same vigor, while keeping alliance partners happy and avoiding populist measures to regain public support.

Policy continuity is now emerging as a crucial factor for global money managers weighing investments in the world’s fifth-largest stock market. Next month’s budget will be the new government’s first test, as fiscal discipline has been a hallmark of Modi’s decade in power.

“People are still in a wait-and-see mode until we see what policies are likely to come up, how are they are going to fund them and what’s the give and take the coalition has to make,” said Rahul Ghosh, an equity portfolio specialist at T. Rowe Price in Singapore. “We’re evaluating our India positioning and considering whether we should add more.”

Skepticism from foreign investors is evident. They sold more than $2 billion of local shares on a net basis on Tuesday and Wednesday, even as buying by local funds and retail investors helped the benchmark NSE Nifty 50 Index climb to a new record Friday, recouping losses spurred by the stunning election result.

Modi’s 10 years in office have ensured political stability and policy continuity, making India a preferred investment destination for global funds despite its expensive valuations. During this period, India’s equity market has grown over 250% and is now nearing $5 trillion in value.

However, a forward price-to-earnings ratio of about 23 times for the MSCI India Index makes the market one of the most expensive globally. This leaves little room for disappointment when investor optimism toward beaten-down Chinese equities is returning. The Indian gauge trades at a premium of more than 80% to the MSCI Emerging Markets Index and 130% to the MSCI China Index.

A key risk is the potential slowdown in policy-making under a coalition government. Modi may need to make concessions to alliance partners, such as offering them key cabinet positions, to maintain their support.

“I’ll adjust my playbook depending on growth assumptions, which will be dependent on certainty of policy,” said Niraj Bhagwat, equity portfolio manager at Wellington Management in Singapore. “Markets will keenly watch certain key ministries such as finance or roads and highways, and whether there are credible faces heading them.”

A reduced mandate has also sparked a debate among investors that Modi may announce populist measures, likely shifting focus away from upgrading infrastructure, which has been a top priority.

Modi stock chart

For some global funds, any weakness in Indian stocks presents a buying opportunity in what they view as one of the world’s most-promising economies, driven by a rising middle class and strong demographics.

Just days before the election result, S&P Global Ratings signaled a possible upgrade to India’s sovereign credit rating, citing stronger fundamentals. Economic growth topped 8% in the fiscal year that ended in March, beating estimates, official data showed two days later.

Historically, Indian stocks have performed well under coalition governments. The MSCI India Index surged more than 180% during the 2004-2014 period — more than twice the MSCI World Index — when a Congress-led alliance ruled the nation.

“There can be a slowdown in policy making and potentially more populist policies, but we do believe that the BJP’s pro-growth, investor-friendly agenda will continue,” said Ashish Chugh, a portfolio manager at Loomis, Sayles & Co., an affiliate of Natixis Investment Managers. “India has many structural growth drivers that will continue to play out.”

However, some investors are becoming defensive and more selective as they await proof that growth-focused policies will remain in place.

“There was a perception of zero risk earlier, which is now gone,” Sailesh Raj Bhan, a fund manager at Nippon Life India Asset Management Ltd. in Mumbai. “Now the approach must be about buying good businesses at sensible prices.”

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