What powers the global outperformance of Indian stocks

In that same period (Jan-mid Oct), the DJIA (USD denominated) has lost 17.5 per cent, and the Frankfurt DAX has lost 21.7 per cent (Euro-denominated) and London’s FTSE (GBP denominated) has lost 7.8 per cent. Among large emerging markets, Shanghai Composite has lost 14.9 per cent (RMB denominated).

The comparative outperformance, or defensive strength of the Nifty, is related to several factors. One is simply that India is touted to be the fastest-growing large economy this financial year, even though India’s GDP estimates have also been pared several times, and the estimates probably don’t reflect fully the weakness in the relatively large informal segment of the economy for long-standing infirmities, gaps and redundancies in the estimation methodology. Nevertheless, as things stand, the prognosis for growth in China, Indonesia, Brazil, South Africa and of course, Russia is much poorer. Many of these economies too have GDP estimation challenges and weaknesses.

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The rupee has dropped around 10.8 per cent against the US dollar but it has gained versus the euro, the yen and the pound. As a result, India has seen relatively less outflow of global capital, even though the FPIs have sold a whopping net ₹1.77 trillion in equity since January and the RBI has spent large sums of dollars defending the rupee. Domestic institutions have found the resources to absorb those FPI sales. Indeed, domestic institutions have bought a net ₹1.94 trillion since January, which has been enough to balance retail exits as well.

Apart from global macro considerations, there are other factors to consider. One is K-shaped growth trends across the Indian economy. The informal economy has been hammered by a series of negative developments over the past several years — demonetisation, the GST, and finally the pandemic, which led to a catastrophic drop in employment.

But the formal economy has done reasonably well through this period — indeed, one could argue that the GST has led to de-facto formalization of the economy, with larger, formal sector firms cornering small informal firms’ market shares. Listed companies, which are by definition part of the formal economy, have also done well in this way.

The pandemic led to a series of enforced cost-cutting measures and corporates have enjoyed strong profit growth as a result even though revenue growth has not been strong. Many large concerns have successfully deleveraged balance sheets, retiring expensive debt. As a result, large companies have stronger balance sheets and a proven ability to weather storms, and both these attributes make them attractive to the global investor.

But the most crucial underpinning for the outperformance of Indian stocks may be the prevalence of negative real interest rates. Interest rates have been negative in real terms since September-October 2021, when inflation started spiraling up. The RBI held down policy rates until May 2022, when it instituted an out-of-turn hike and other measures to tighten liquidity.

However, even after three hikes, rupee interest rates are still low or negative in real terms, compared to inflation. For example, the 10-year government bond is traded at 7.4 per cent and the 364-Day Treasury Bill is traded at 7 per cent in an environment where CPI inflation is running at 7.4 and the Wholesale Price Inflation is at 10.7 per cent.

Low rates automatically support higher valuations for risky assets such as equity. Investors value businesses on the basis of expectations of future profits, and a comparison of those returns to returns available from safer assets such as low-risk debt or risk-free government debt. The current value of (estimated) future profits is higher if the (known) returns from debt are low.

That is very much the situation in India — interest rates are low and the Nifty is sustaining a price-earnings multiple of 21-plus. This valuation equation will change as and when nominal interest rates climb above inflation, as it will, if the RBI continues to hike and higher policy rates are transmitted through the financial system. Once that happens, the risk-free return will be higher.

Or, the equation will change as and when investors pare down earnings expectations. We will get a better sense of this once Q2 results and management guidances are available on a broad scale across multiple sectors. But many corporates have already flagged possible slowdowns.

Given a deteriorating macro-environment and the central bank monetary stance, both these things could happen: earnings expectations may fall and real interest rates may rise and that could cause a big sell-off. But until then, India’s stock market indices might continue to show relative outperformance.

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