As the monsoon season drew to a close in India last September, the local economy looked waterlogged.
The nation's currency, the rupee, had just slid to an all-time low against the dollar, as quarterly growth fell to just 4.4%, the slowest growth rate since the global economic crisis of 2009. In response, Indian stocks accelerated their declines as it became increasingly apparent that any economic turnaround would be slowing in coming.
Yet as is often the case with many markets, sectors, or even individual stocks, the point of maximum pessimism is often the best time to invest.
That was surely the case with India stocks, which have staged a remarkable comeback. In just the past 10 months, India's SENSEX index has rallied an impressive 35%, and many India-focused exchange-traded funds have done a lot better than that. (These ETFs have benefited from a rebound in the rupee, which has magnified gains.)
India's new prime minister began his campaign last fall on a platform of economic rejuvenation, and Indian stocks have already begun to reflect an anticipation of much better days ahead. India's Economic Times has looked at 15 of Modi's potential economic reforms, which focus largely on reducing spending on subsidies for diesel fuel, fertilizers and social service contracts. Modi also intends to boost prices for railway tickets while introducing broader labor reforms.
All of these moves will likely help strengthen the Indian government's finances and also improve business confidence. But such moves can also trigger social unrest, or at least impose a period of anemic economic growth as consumers feel a deeper strain.
In an interview with India's BusinessToday, Jagannadham Thunuguntla, chief strategist and head of research at SMC Global Securities, noted that "The new government comes in with extreme expectations."
Modi is aware of the pressure. In a speech last week, he said, "I know my popularity might go down due to these hard decisions -- people might be annoyed with me, but they will appreciate it later."
Many expect Modi to radically pare back the country's bloated bureaucracy, replacing corrupt officials with more sophisticated technocrats. Dozens of ministries may be scrapped altogether. That's likely to trigger a backlash among entrenched interests, and Modi will need to muster all of the political capital he can to succeed.
More importantly, newly bullish investors may be underestimating just how deep a hole India has dug for itself. For example, there are an estimated $100 billion in non-performing loans being carried by India's banks, or roughly 10% of the total loan portfolio. And GDP growth has moved below 5% at a time when inflation is around 8%.
One of the reasons that India's inflation rate remains stubbornly high is an extended cycle of under-investment in the nation's infrastructure. Back in 2003, India spent the equivalent of 4% of its GDP on infrastructure. Today, that figure stands below 2%. Even as Modi tightens the spigot elsewhere, he'll have to boost spending on roads, ports, bridges and other key components to eliminate the inflation-boosting bottlenecks.
Yet it's the deficits that should make investors especially wary. Some countries have high budget deficits while some others have high trade deficits. In an April report by the International Monetary Fund (IMF), India was cited as the only country in the G-20 to have high levels of both kinds of deficits.
India's trade deficit stems from an overwhelming reliance on energy imports. The country relies on oil exports to meet more than 80% of its domestic consumption, which is a deep concern when oil prices have begun to surge higher. Rising oil prices will boost inflation and also sap foreign currency reserves. According to the Financial Times, every $1 increase in the price of crude oil adds another $1 billion to India's import bill.
To be sure, India's Modi has squarely addressed the country's deep systemic woes. If he was able to enact every single economic change he envisions, he would set the stage for long-term economic growth for India, albeit with short-term economic pain.
Yet Indian prime ministers rarely have a free hand when it comes to implementing change. The entrenched interests are just too strong.
Risks to Consider: As an upside risk, rising Indian business confidence may lead to a cycle of capital investment in job growth, which would help boost tax receipts and soften the social impact of austerity programs.
Action to Take --> India will be a fascinating country to watch in coming years, as a broad litany of woes finally get addressed. Yet the recent sharp rebound in many India ETFs suggests a more cautious stance. The coming quarters will likely see a great deal of resistance to Modi's reforms, and any moves to water them down will be seen as a clear negative by the investment community. Meanwhile, the country's rising energy bill, aging infrastructure, persistently high inflation and slowing growth rates may conspire to blunt the impact of Modi's reforms. As a result, profit-taking or even short-selling some of these fast-rising ETFs may be the best course for the rest of 2014.