Sharp outperformance of Indian markets over EMs, world continues

Leads to surge in valuation premium; Experts caution investors

Most global markets often march in lockstep. However, what has played out this year—more so since August—has stunned many on the Street. The Indian market has stolen a march over its emerging market (EM) and world peers. For a second straight month, the Nifty has outperformed the MSCI World index by more than 6 percentage point (ppt), while the MSCI EM for a fifth straight month.

China’s equity market correction due to the regulatory crackdown has weighed on the performance MSCI EM index—where it has more than a third of weightage. The MSCI World index is dominated by developed world nations such as the United States, Japan, United Kingdom and France –all of whom have severely lagged India since August.

In August, the Nifty rose 8.7 per cent, while the MSCI World and MSCI EM rose just 2.4 per cent each. So far this month, the Nifty has gained over 4 per cent, even as the MSCI World and MSCI EM indices are down 2.1 per cent and 3.5 per cent respectively.

Globally, investors have scaled back their bullish bets in recent weeks amid concerns of a spillover from potential default at China’s Evergrande, imminent taper by the US Fed and rise in infections due to the delta variant.

Factors like increased pace of vaccination; strong domestic and retail flows; reallocation of foreign flows due to China’s regulatory crackdown and sharp rally in large-cap index heavyweights has seen the domestic charge ahead of others.

While India always commanded a premium to many global peers, the recent outperformance has further widened the valuation gap, prompting some experts to raise caution.

“The Nifty (in dollar terms) has outperformed the EM benchmarks by 19ppt/22ppt/33ppt on a 90 day/180 day/365 day basis. Our long term daily rolling analysis suggests that such periods of outperformance are unlikely to significantly extend beyond the current levels. Also, such periods of outperformance are usually followed by India underperforming by 11 ppt, 6 ppt and 7 ppt on average in the following 90, 180 and 365 days respectively,” said Mahesh Nandurkar, Head of Research & MD, Jefferies in a note.

The price-to-earnings (P/E) of Nifty currently is over 80 per cent more than the MSCI EM index, which is the highest since the 2007-08 Bull Run. Indian markets have traded at an average premium of around 40 per cent since 2007.

“The MSCI India Index currently commands a valuation premium of 85 per cent compared to the MSCI EM Index and 24 per cent compared to the MSCI World Index. (versus 10-year average of 7 per cent). We continue to expect the higher P/E premium for the Indian equities to continue given the market’s improved fundamentals. India’s exports are showing a strong recovery, forex reserves are making new highs and more importantly the government’s tax collections so far are much better than expected. In terms of equity flows, too, India is showing remarkable resilience despite high valuations,” said Jitendra Gohil, Head of India Equity Research, Wealth Management, Credit Suisse.

Gohil, however, is advising investors to reduce some risk in their portfolio by cutting exposure to small and mid-cap stocks, while adding more large-caps.

The Nifty currently trades at a 12-month forward P/E of 23.3 times. On the other hand, the MSCI EM and MSCI World trade at just 13 times and 19.3 times respectively.

Sanjeev Prasad, MD and Co-Head, Kotak Institutional Equities says such rich valuations could lead to some correction.

“The rich valuations of the Indian market and of most sectors after the sharp rerating in the multiples of most stocks from their pre-pandemic levels raise the prospects of a pullback in the market and/or modest returns for a ‘longish’ period of time,” he said in a note this week.

“However, we would rule out a severe correction in the market as potential bad news in the form of earnings downgrades (from global factors) and/or higher bond yields may not be bad enough.”