Avoid Indian stocks for now

by Levi Folk | April 10, 2007

India’s stock market appears to be capitulating, a victim of an overheating economy. Stock-market returns have discounted an economy that some say can grow at near double-digit rates, but that appears unrealistic. Equity investors will continue to be punished in the near term for their optimism as Indian interest rates are raised to slow the economy and inflation.

Canadians can invest in India in several ways, but two exchange-traded funds come to mind: Blackstone Asia Advisors LLC’s US$1.8-billion closed-end India Fund Inc. (IFN/NYSE) and the US$897-million Morgan Stanley India Investment Fund Inc. (IIF/NYSE).

Those planning to diversify their holdings with Indian stocks should be prepared for a downturn, at least in the short term.

In the most recent quarter, India’s economy grew at about a 9% an annual rate—faster than can be accommodated without fuelling inflation, according to Brian Dumas of Lombard Street Research. The country’s economy has been overheating, and heavy borrowing has been evident in many sectors.

Easy credit conditions have led to rampant growth in domestic credit. Broad measures of the money supply have been expanding at more than 20% annually—the same levels seen in 1998 when the stock market last peaked. And credit has been running at a 30% rate of growth.

This has led to inflation in most parts of the economy. Housing prices doubled in Mumbai from 2005 to 2006 on the back of strong mortgage origination. Wholesale price inflation is running at a 6.6% annual rate after bottoming at 4% in the first quarter of 2006. Consumer price inflation is also on the rise nearing an 8% annual rate. All indications are that the economy appears to be operating above capacity.

The government has been trying to pull in the reins since last year, but it would appear that monetary policy still remains too accommodative.

The Reserve Bank of India , the central bank, has been raising rates slowly in small increments from 6% to 7.25%, but interest rates adjusted for inflation — the real rate of borrowing—are low, close to 2% for long bonds and short-term treasury bills in February, according to the International Monetary Fund.

The stock market has been richly priced, however, as investors have been attracted to the strong economic growth that has fed double-digit increases in corporate earnings. India’s Sensex Index grew at a 40% annualized rate between January, 2003, and October, 2006.

This was reflected in a rich price-to-earnings (P/E) multiple of 20 on the index in January, which declined to 19 in February as the market fell more than 10%.

Profitability has indeed been running high, and the Indian market boasts some world-class growth companies in technology and pharmaceuticals to list just a few important sectors.

However, the trajectory for interest rates is likely higher. Growth needs to be brought down to trend or even below to stop inflation from rising. India does not appear to have China’s ability to grow at double-digit rates without triggering inflation. The country suffers from a serious infrastructure deficit which will keep it permanently on a slower growth track relative to China .

Service costs for infrastructure are 50% to 100% higher in India over China according to the Financial Times, and that is costing the country several percentage points in potential GDP growth. As a result, India’s manufacturing sector remains a fraction of China’s, and that is reflected in the country’s smaller share of global goods exports 1.2% versus China’s 9.9% in 2005.

Unfortunately public spending on infrastructure also remains depressed relative to China’s spending habits: one seventh the level, according to Morgan Stanley. And private spending also lags China , judging by the huge flow of foreign direct investment that goes to China .

All this suggests that India’s economy is currently bumping up on its growth limits.

This has implications for stock market investors, who have also pushed valuations to the limits. As higher interest rates are needed to keep the economy from following a boom-bust trajectory, Indian stock-market gains are likely on hold.