India and China: Redefining resilience

Risk assets sold off sharply in early August on the back of a mix of factors, including concerns over the sustainability of AI spending and monetisation, fears of a US recession and the unwinding of the yen carry trade. Fig. 1. China and India were among the few Asian markets that performed better than the rest, underpinned by idiosyncratic factors. We believe that these factors will continue to position these markets favourably during future periods of volatility.

Fig. 1. Performance of selected equity markets on 5th August

Source: Bloomberg. MSCI Indices in USD terms.

India’s relative outperformance during the recent sell-off may come as a surprise given concerns over its expensive valuations. However, unlike other Asian markets which are more dependent on foreign inflows, the Indian equity market is more reliant on domestic flows, which tends to be “stickier”. Although India is often viewed as a popular market among foreign investors, India’s relative portfolio weight in Global Emerging Market (EM) funds is at its lowest since 2005, despite the market’s outperformance. Fig. 2.

Fig. 2. MSCI India’s portfolio weight and total return relative to MSCI EM

Source: EPFR country allocation, FactSet, Morgan Stanley Research. Data as of July 31, 2024. *Fund weight as of June 2024.

MSCI India also has a low beta to the MSCI USA Index, as shown in Fig. 3. India’s lower revenue exposure to North America potentially reduces its vulnerability to US recession risk. India’s Information Technology (IT) services sector, which has the highest exposure to the US, has already experienced slower growth over the last one and half years, driven by vendor consolidation.

Fig. 3. Index beta to MSCI USA vs revenue exposure to North America

Source: Bloomberg, Morgan Stanley Research; Data as of July 26, 2024; Note: Betas are calculated based on MSCI indices unless specified otherwise; weekly returns, rolling 52 weeks.

With the Federal Reserve (Fed) poised to cut rates in the coming months, the strength of the US dollar may moderate as interest rate differentials narrow between the US and the rest of the world. Historically, Emerging Markets tend to outperform when the dollar index weakens. At the same time, Fed rate cuts potentially give the Reserve Bank of India room to bring rates lower (if needed) without stoking volatility in the Indian rupee.

Like India, we believe that the Chinese equity market will be relatively resilient in the face of global volatility given its trough valuations, low exposures among institutional investors and improving fundamentals in selected key sectors.

At a 12-month forward price-to-earnings ratio of 9x, MSCI China is trading at a trough relative to its own history and the region. The challenges facing the Chinese economy are well known – a weak property market, low consumer confidence and a lack of effective stimulus from the government. A sizeable stimulus package will be needed to lift investor sentiment. Till then, with the government encouraging companies to return more cash to shareholders, dividends and share buybacks should help to stabilise the market. Fig. 4.

Fig. 4. Dividends and buybacks have been an important component of returns for MSCI China

Source: MSCI, FactSet, Goldman Sachs Global Investment Research (as of 24 June 2024).

China is currently one of the most unloved equity markets amongst investors - global investor positioning in Chinese equities is at its lowest in 12 years. This suggests that the market has less room to fall further if overall investor risk aversion rises. Fig. 2. had earlier shown that like MSCI India, MSCI China’s revenue exposure to North America is low compared to the other EMs, which should also make it less vulnerable to US recession risk. On the macro front, the US’ share of China’s total exports has fallen from a high of 20% in 2001 to 14% in the first quarter of 2024. In contrast, ASEAN’s share of China exports has more than doubled from 7% to 17% over the same period.

Importantly, MSCI China’s correlation with other markets such as Japan, Taiwan and Korea has been trending down. Fig. 5. Its correlation with MSCI India is even lower. As such, combining both markets in a portfolio can provide investors with significant diversification benefits.

Fig. 5. Rolling correlation with MSCI China

Source: FactSet, MSCI, Goldman Sachs Global Investment Research (15 Aug 2024).

Besides the market sell-off in August, we note that the Indian stock market has remained resilient to two unexpected domestic “shocks” this year - Prime Minister Modi’s smaller than expected majority in the June election and the capital gains tax increase in the July India budget.

Given the strength of its domestic inflows, it is unlikely that a US recession would derate the Indian equity market. During periods of market volatility, our value focus should allow us to participate in the India structural growth story while providing investors with some buffer i.e. potentially falling less when the market falls.

With periods of volatility expected in the coming months, MSCI China’s trough valuations, low expectations among investors and low correlations with other equity markets should make the market relatively resilient. Although the performance of the Chinese equity market has been disappointing over the last few years, it is in such conditions that value investors are able to uncover attractive bargains. Notably, the internet sector, which accounts for 39% of the MSCI China Index, has been enjoying positive earnings momentum, as e-commerce competition declines and share buybacks accelerate.