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Indian equity will continue to deliver inflation-beating returns, but they will be lower compared to the last 25 years
Rains have been scarce over the last two years; commodity prices have crashed; banks are sitting on a pile of bad debts that threatens to pull them under; rural consumption is severely hit; the Sensex is too expensive — are these statements flashing in the media every hour, making you nervous about your equity holding? Well, if you are a long-term investor, you don’t need to pay too much attention to this noise.
It is true that these events could determine how stocks move over the next two or three years, but long-term allocations to equity should be based on the macro trends that are unfolding globally and the role that India will play there.
Indian equity market has performed very well over the last twenty five years, led by liberalisation of the economy and a shift to services-led growth. Foreign investors, too, have been quick to take a share in this pie.
But will this growth sustain in the future? What are the returns that investors in Indian equity can reasonably expect over the next three decades, until 2050? What are the significant trends that are likely to evolve over this period and what can be the takeaways from these trends for Indian investors?
To answer these questions, we used the future GDP projections made by various international organisations to derive the growth rates for equity markets. While there are many risks that can hamper these projections, Indian equity does appear to be in a sweet spot, at least up to 2050.
Where are we?
To understand the trajectory of Indian markets over the next three decades, we need to spend some time looking at the road traversed so far. Asia was the one-eyed king in a kingdom of the blind, as Raghuram Rajan recently put it, prior to the industrial revolution in 1700s; contributing to almost half of the global GDP then. That was a time when all regions were equally poor, dependent on land and other natural resources. But the European and North American countries made rapid strides in improving their income and savings due to industrialisation and international trade in the 18th and 19th centuries. This helped improve the productivity of their people, taking the per capita wealth of their citizens much higher than other countries. By 1950, the share of Asia in global GDP had shrunk to 15 per cent, according to Centennial Group’s (strategy and policy advisors) estimates. But the last sixty years have seen rapid improvement in productivity in all emerging economies, including those in Asia, led by political change in many countries. The fast growth in population also contributed to this growth. This has resulted in the share of Asia in global GDP rising to 40 per cent by 2015; with EMEs accounting for around 55 per cent.
To understand the trajectory of Indian markets over the next three decades, we need to spend some time looking at the road traversed so far. Asia was the one-eyed king in a kingdom of the blind, as Raghuram Rajan recently put it, prior to the industrial revolution in 1700s; contributing to almost half of the global GDP then. That was a time when all regions were equally poor, dependent on land and other natural resources. But the European and North American countries made rapid strides in improving their income and savings due to industrialisation and international trade in the 18th and 19th centuries. This helped improve the productivity of their people, taking the per capita wealth of their citizens much higher than other countries. By 1950, the share of Asia in global GDP had shrunk to 15 per cent, according to Centennial Group’s (strategy and policy advisors) estimates. But the last sixty years have seen rapid improvement in productivity in all emerging economies, including those in Asia, led by political change in many countries. The fast growth in population also contributed to this growth. This has resulted in the share of Asia in global GDP rising to 40 per cent by 2015; with EMEs accounting for around 55 per cent.
This growth is reflected in the improvement in the GDP per capita of India in PPP (purchasing power parity) terms. The number grew from $485 in 1981 to $5,701 in 2014. The stock market has kept pace with the strides made in income levels and the Sensex has grown at 16 per cent annually since 1980.
But will this growth continue over the next 34 years?
Looking ahead
To answer this question, we used studies done to project future GDP growth, to derive the expected returns from equity market from 2016 to 2050. The GDP growth assumptions made by PwC in its report, “The World in 2050, Will the shift in global economic power continue?” and by The Economist Intelligence Unit’s (EIU) special report, “Long Term macroeconomic forecasts, key trends to 2050” published last year have been used as a basis for our projection.
To answer this question, we used studies done to project future GDP growth, to derive the expected returns from equity market from 2016 to 2050. The GDP growth assumptions made by PwC in its report, “The World in 2050, Will the shift in global economic power continue?” and by The Economist Intelligence Unit’s (EIU) special report, “Long Term macroeconomic forecasts, key trends to 2050” published last year have been used as a basis for our projection.
The EIU is extremely bullish about the growth prospect of the Indian economy. It expects nominal GDP to increase from $2 trillion in 2014 to $63 trillion by 2050. India is expected to be the third largest economy in nominal GDP terms; improving from the ninth position in 2014. India’s GDP is projected to be just slightly behind the US’ $70 trillion in 2050, with China leading the pack with $105 trillion. Many other EMEs such as Indonesia, Brazil and Mexico are also expected to feature in the top 10 by 2050.
The PwC report projects India’s nominal GDP to grow to $7.3 trillion by 2030 and $27.9 trillion by 2050, making the country occupy the third rank. The report expects growth in India to moderate after 2020. But despite this slowdown, the report expects India to remain the fastest growing economy in real GDP terms till 2050.
Growth rates in Indian market
So what’s the return that investors in Indian equity can expect? The result is quite optimistic. Returns from equity are likely to range between 8 and 11 per cent annually over the next 34 years. While this is lower than the 15 per cent return that many analysts and financial advisors factor in to project equity returns over the long-term, it is likely to be higher than returns from other asset classes and also succeed in beating inflation. We arrived at the growth rate in Indian equity market through two methods. One, we projected the market capitalisation of Indian stock market in 2050 based on EIU and PwC estimates. Since the company earnings and future stock price expectations are linked to the economic growth, there is an established link between nominal GDP and market capitalisation.
So what’s the return that investors in Indian equity can expect? The result is quite optimistic. Returns from equity are likely to range between 8 and 11 per cent annually over the next 34 years. While this is lower than the 15 per cent return that many analysts and financial advisors factor in to project equity returns over the long-term, it is likely to be higher than returns from other asset classes and also succeed in beating inflation. We arrived at the growth rate in Indian equity market through two methods. One, we projected the market capitalisation of Indian stock market in 2050 based on EIU and PwC estimates. Since the company earnings and future stock price expectations are linked to the economic growth, there is an established link between nominal GDP and market capitalisation.
According to Bloomberg, the average market cap in India as a percentage of GDP was 75 per cent for the 10-year period between 2004 and 2014. We used this figure to project future market cap to 2050. This is a slightly conservative number as it is half of the peak value of 146 per cent recorded in 2007.
The size of the Indian market is expected to increase to $21 trillion based on the GDP projected by PwC and to $48 trillion according to the EIU’s projection. That gives us the annual growth rate of 8 per cent according to the PwC estimate and 11 per cent according to the EIU estimate.
The annual GDP growth was 11 per cent in nominal terms between 2000 and 2014. Therefore the projected growth rates for equity returns for the future are in line with the past growth.
We also tried to arrive at the projected returns on Indian equity by doing regression analysis of sensex EPS growth and nominal GDP growth of India since 1999 on a quarterly basis. The regression coefficient was 0.74. If we project Sensex’ growth using this metric on a total return basis, we arrive at a slightly lower growth between 7 and 9 per cent every year up to 2050. These are, however, the returns expected from the Sensex. Returns of the market as a whole could be higher or lower.
Is this possible?
To understand if this growth rate is achievable, we looked at the growth rates clocked by major indices over the last 100 years. The analysis was constrained by the fact that many indices in the emerging markets were formed only in the late nineties or early twenty first century.
To understand if this growth rate is achievable, we looked at the growth rates clocked by major indices over the last 100 years. The analysis was constrained by the fact that many indices in the emerging markets were formed only in the late nineties or early twenty first century.
The premise established by the GDP growth rates — that developed economies slowed down after 1950, giving way to emerging economies — is reflected in the returns delivered by major stock market indices as well. The Dow Jones Industrial Average, for which data is available from 1896, has grown at a healthy annual growth rate of 7 per cent from 1896. But the pace of growth has slowed down to just 2 per cent since 2000, when emerging markets began forging ahead.
If we compare the annual growth rates of stock market indices since 2000, indices from developed countries such as the UK and Japan have recorded declines. The emerging and frontier market indices such as Brazil’s Bovespa and Vietnam’s Ho Chin Minh index, on the other hand, have recorded annual growth of more than 7 per cent.
The Sensex was among the out-performers in this period recording annual growth of 11 per cent from 2000 as the country was given a premium for its favourable demographics and high growth rates.
Will this growth continue over the next 34 years? This appears possible because the emerging economies are just beginning to converge with developed economies; which have reached this stage of development after 250 years of growth. Given the potential for convergence, India seems set to grow at least up to 2050 and this will translate into healthy returns from stock markets.
What does it mean?
The first question that will arise once presented with the growth rate for equities is — will it be enough to beat inflation? Well, the RBI has made itself the prime sentinel of inflation rates and is not likely to let it gallop too high. The EIU projects India’s inflation to hover around 4.6 per cent by 2020. The IMF forecasts a slightly higher 5 per cent by 2020. While we do not have projection for inflation beyond 2020, if inflation stays around 5 per cent, equity will have no difficulty in giving healthy real returns.
The first question that will arise once presented with the growth rate for equities is — will it be enough to beat inflation? Well, the RBI has made itself the prime sentinel of inflation rates and is not likely to let it gallop too high. The EIU projects India’s inflation to hover around 4.6 per cent by 2020. The IMF forecasts a slightly higher 5 per cent by 2020. While we do not have projection for inflation beyond 2020, if inflation stays around 5 per cent, equity will have no difficulty in giving healthy real returns.
The returns by equity will also not find it too difficult to better debt instruments as interest rates tend to move lower as economies expand. This is because the risks associated with lending move lower in larger economies, bringing down the cost of funds. While a move towards zero or negative rates, prevailing in some countries today, may not be likely, a run-away increase in interest rates is also equally unlikely.
In other words equity could well rule the roost over the next three decades. But what are the themes that are likely to play out in the run-up to 2050?
Themes for the future
Population growth: India will continue to have an advantage over many emerging market economies including China, over the next 35 years, as its population is expected to continue growing, ensuring that there are adequate number of people in the working age group (between 15 and 55). The UN projects India’s population to grow at 0.7 per cent every year to 2050. This will result in the population growing to 1.4 billion people in 2022, 1.5 billion in 2030 and 1.7 billion in 2050. On the other hand, China’s population is expected to remain fairly constant until the 2030s, after which it is expected to slightly decrease.
Increasing population will keep the domestic consumption story going for India. Meeting the basic demands of the population will help revenue growth of consumer non-discretionary, real estate and textiles companies. Growing literacy level and higher income will help speed up financial inclusion and the growth of the banks and other financial institutions. Median age of Indians is set to increase from 21.3 in 1950 to 31.2 in 2030 and 37.3 by 2050. While this does show a drop in fertility level, the population will still be in the working age, thus aiding productivity. Life expectancy of Indians is also projected to improve to 75.9 by 2050 and 84.6 by 2100. A larger portion of ageing population will mean brisk business for pharma and healthcare companies. Insurance, both life and general, can also witness higher growth.
Urbanisation: Much of the growing population in India is projected to move to cities from rural areas, according to projections made by the UN. Proportion of urban population in India is expected to increase to 50 per cent by 2050 from 32 per cent in 2014. China and India are expected to contribute more than one third of the global urban population increase between 2014 and 2050.
It is obvious that the cities in India are not adequately equipped to support an increasing inflow from rural areas. Along with extension of the cities and towns present today, new smart cities will also be needed to support this migration. This translates into huge opportunities for the real estate sector, infrastructure players including those in construction, power, oil & gas etc, producers of building materials such as cement, steel, tiles, paints, etc.
Rise of the middle class: According to the Centennial Group estimate, the world is set to experience an explosive growth in the number of people who can be classified as middle class (per capita income between $10 and $100 a day in PPP terms). This segment is expected to rise to 84 per cent of world population by 1950. India too is expected to predominantly have middle or upper income families.
Growing aspirations of this segment will keep the tills of consumer durable, automobile, media and entertainment and travel and tourism related companies ringing. Service providers should also have no dearth of opportunities.
Technology: Innovations to improve productivity and to change the way things are currently being done will be the game changer for countries in the years to come. As processes go digital and automation does most of the work currently being done by people, productivity will improve greatly. The challenge for Indian companies will be in scaling up the value chain quickly. According to estimates, Indian companies will find the convergence with other technologically superior countries such as the US, difficult in the short term. But they are expected to catch up over the long term.
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