The mix of India’s falling beta to emerging markets is symptomatic of lower return expectations, which then leads us to the question – why are foreign investors skeptical about the India story? We attempt an explanation.
India’s Falling Beta To Emerging Markets
India’s beta versus emerging markets has fallen 37 percent since Dec 2014 to a 13-year low. We measure the beta on a three-year rolling basis using weekly U.S. dollar returns of MSCI India Index and MSCI Emerging Markets Index. The beta is about 0.4 standard deviations below its long-term average (prior to 2002 India was a distinctly low-beta market) and at the 66th percentile of the long-term range. Why is the beta falling and what does it mean for investors are two questions we attempt to answer. However, firstly, we recap of the theory of beta.
The Theory Of Beta
We know that beta is a measure of systematic or market-related risks, i.e., risks that cannot be diversified away. Systematic risks are caused by socioeconomic and political events that affect the returns of all stocks, and beta is an estimate of how the returns from a stock will move relative to the returns from the market. When measuring the beta of a country index versus a group of country indices, as in this case, India's beta relative to emerging markets is an estimate of how the returns from the MSCI India will move relative to the returns from the MSCI Emerging Markets Index.
Why Has India’s Beta Fallen? The Mathematical Response
Mathematically speaking, beta is the product of the correlation of returns between a stock (or India Index here) and the market (or Emerging Markets Index, in this example) and the relative volatility of the stock’s returns to market returns. The striking feature of the 37 percent collapse in India’s beta since December 2014 is that it has been led by a fall in India’s relative volatility to emerging markets rather than its return correlations. Simply put, this means that emerging market performance-related impact on India is intact and, in fact, slightly higher in recent months. However, the portion of beta driven by non-emerging market performance-related impact (i.e., India’s own idiosyncrasies) is down significantly. Indeed, the relative volatility is 1.8 standard deviations below average and at its lowest level ever.
Where Is The Idiosyncratic India?
Thus, price action (i.e., beta) suggests that the India idiosyncratic story is at its weakest in history and India’s returns are being driven largely by emerging market factors. Developments of the past four years suggest that India’s distinctiveness versus emerging markets should have risen and not fallen. Indeed, India’s macro stability aided by positive real rates and fiscal consolidation, and change in funding mix of the external deficit from portfolio flows to direct investments is at its best in decades. Also, the demand for equities has shifted from foreigners to domestic sources, which again is a factor that should raise relative volatility. Why is the relative volatility down so much?
Why Has India’s Beta Fallen? The Fundamental Matrix
We think the fall in relative volatility is down due to the persistent growth disappointment of the past few years. This probably means that investor confidence in India’s growth story is low. And within the aggregate investor base, this erosion in confidence is concentrated with foreign portfolio investors who have reduced their India position in the average emerging markets portfolio to a seven-year low – explaining the fall in India’s relative volatility and beta versus emerging markets.
We believe that India’s price-to-equity multiple is at about 12 times normalised earnings versus the headline multiple of 18 times. Earnings have been in their deepest and longest earnings recession in history having lasted in excess of seven years and resulting in a 20 percent draw-down from the top. If we are right, and the earnings cycle has troughed, it may also mean that India has likely become a counter-cyclical market. Note that profit share in gross domestic product is at its high point in the developed world compared to India, where it has hit all-time lows. Counter-cyclical stocks naturally have low beta and India fits that description.
What Are The Implications Of Lower Beta?
- A lower beta (under the Capital Asset Pricing Model) implies that the cost of equity has fallen, i.e., future returns are likely to be lower than earlier estimates. Lower expected returns are a recipe for outperformance.
- A low beta also means lower sensitivity to global returns. In a low-return world, which our global strategists believe we are in, this implies that India will likely outperform.
History does not suggest that low relative volatility means that India is unequivocally set to outperform. We are arguing for India’s outperformance because of: a) the growth cycle is turning, in our view, and hence relative volatility will rise, i.e., return expectations may prove to be low, and b) our global equity outlook is not sanguine, which again plays in India’s favor from a beta perspective.
Of course, the practical difficulty with beta persists, which is that computed beta is backward-looking and a constantly changing number. Hence the question is: what will shift the beta and how will that impact India’s performance? We see three catalysts.
What Are The Risks/Catalysts For The Beta To Rise Or Fall?
If India’s beta and relative volatility rise from current levels, it will coincide with the market doing better than its peer group. Such a rise will likely be led by growth outperforming expectations. Further growth disappointment will cause relative volatility to drop even more and take beta lower. The other two risks are oil and political. Rising oil prices will likely lift correlations between India and the emerging market asset class and raise India’s beta, but with negative consequences on Indian equity returns. Poor political outcomes, on the other hand, counter-intuitively will depress relative volatility taking India’s beta lower with the stock market.
Ridham Desai is managing director at Morgan Stanley India and also serves as head of equity research and India equity strategist.
The views expressed here are those of the author’s and do not necessarily represent the views of BloombergQuint or its editorial team.