India is swiftly catching up to China as the largest country in the MSCI emerging markets index, presenting a dilemma for global investors who are increasingly exposed to India’s buoyant yet costly stock market. The surge in share prices, stock sales, and earnings growth by Indian companies has pushed India’s representation to nearly a fifth of the index, while China’s has declined to a quarter, down from over 40% in 2020. An upcoming MSCI index review could elevate India’s weight to over 20%, surpassing Taiwan and placing it directly behind China.
This narrowing gap has become a significant issue for investors in emerging markets this year. They face a choice between investing in India’s already hot market or China’s relatively cheap stocks, which are suffering from an economic slowdown. Varun Laijawalla, an emerging markets portfolio manager at NinetyOne, noted that the two dominant trades in emerging markets are “long India, short China.” He highlighted the unprecedented valuation gap between the two markets, with Indian stocks trading at 24 times their expected earnings next year, compared to China’s 10 times.
The power of indices in emerging markets is evident, directing billions in passive flows or influencing active managers to adjust their exposure relative to established benchmarks. Kunjal Gala from Federated Hermes remarked on India’s substantial rise in the index from 6-7% a decade ago to nearly 20% now. Despite the high valuations, the index shift presents a challenge for long-term investors focused on ‘margin of safety’ valuations. Gala mentioned that his firm is slightly underweight on India, not due to macroeconomic concerns, but because of the high stock prices.
Domestic inflows into equity funds have played a crucial role. The average annual net domestic flow into equities surged from $12bn between 2016 and 2020 to $29bn between 2021 and 2023, according to Laijawalla. Despite scepticism about the sustainability of these flows and valuations, the high cost of missing out on Indian stocks remains a key concern for investors. India has been one of the best-performing markets globally in local currency terms and has kept pace with US markets in dollar terms. It has also been a top market for “multi-baggers,” stocks that have increased at least tenfold.
However, the one-year forward price-to-earnings ratio is considered one of the least relevant financial indicators in India. Vikas Pershad from M&G Investments pointed out that investors have missed out on returns in India for two decades by focusing on this ratio. Consensus forward earnings per share estimates for Indian companies in the MSCI emerging markets index are similar to other emerging markets. Sunil Tirumalai from UBS noted that while Indian earnings are growing, the pace is not faster than other emerging markets. Despite this, Indian valuations have risen sharply, driven partly by a retail investment boom.
Indian households are investing heavily in domestic equities to counteract low interest rates, which only match official inflation at best. Domestic buying, often through automated monthly transfers to funds managed by large banks, has offset the reduction in foreign institutional investment. Foreign ownership in Indian equities has dropped to an 11-year low, according to Tirumalai. Global investors remain underweight in India due to high valuations, making it difficult for them to find attractive value stocks, as noted by Vivian Lin Thurston from William Blair Investment Management.
China’s weight in the index soared following the inclusion of mainland-listed companies in 2019, though mainland stocks are still not fully included. Historically, countries reaching a 25% weight in the MSCI EM Index have tended to decline from their peaks, observed Jitania Kandhari from Morgan Stanley Investment Management.
Fidelity Emerging Markets Limited (LON:FEML) is an investment trust that aims to achieve long-term capital growth from an actively managed portfolio made up primarily of securities and financial instruments providing exposure to emerging markets companies, both listed and unlisted.
