That giant sucking sound is from India's stock market

The run-up to this year’s Diwali festival was more than a tad dim for India’s stock market. Foreigners pulled out $10 billion in October, even more than they had during the sudden lockdown of the economy during the March 2020 outbreak of Covid-19. The benchmark index posted its biggest monthly decline in more than four years.

Worse, it doesn’t look like the selling pressure has been exhausted. Valuations still appear stretched, even as expectations about corporate earnings start to wane after a string of disappointing results for the September quarter across industries.

In a way, this was expected: India’s consumer economy is weak, and interest rates are high. Car dealers are awash with an all-time-high inventory. If festive-season buying doesn’t clear $9 billion of unsold stock, particularly of smaller vehicles priced below Rs 10 lakh ($12,000), there will be trouble ahead. Shares of Maruti Suzuki India Ltd., the country’s largest automaker, have slumped 18 per cent in just over a month.

It isn’t just consumer durables that are waiting for buyers to show up. After struggling for years with tepid rural demand for staples, the likes of Hindustan Unilever Ltd. are staring at an urban slowdown. India’s income and wealth inequality, among the worst in the world, is finally coming to bite. “There is a top end, and people with money are spending like that is going out of style,” Suresh Narayanan, the chairman of Nestle India Ltd., said recently. “The middle class… seems to be shrinking.”

To see how these concerns are weighing on the market, start with the analysts’ consensus estimate for the year ahead. Stocks in the MSCI India Index are expected to deliver 15 per cent growth in profits in dollar terms, compared with decade’s average of 20 per cent. India is the world’s fastest-growing major economy, with the central bank penciling in 7.2 per cent annual expansion. But as I have written before, large parts of India Inc. haven’t been feeling this growth for some time. Now analysts, too, are turning pessimistic, slashing their forecasts.

Contrast this with China, where the consensus opinion was deeply negative before the recent government stimulus. Now the expectation from MSCI China is that it will deliver profit growth similar to MSCI India in dollar terms. That’s the most optimistic that analysts have been in the past seven years. So where should global investors be heading next, India with its deepening demand funk and rising stress in household balance sheets? Or China, where factory activity is finally showing some proof of life after five months of contraction?

Maybe the story is more nuanced than that. A decade-long, $800 billion surge in investment by large Indian conglomerates, led by forays into newer industries such as semiconductors and electric vehicles, is supposed to trickle down to the rest of the economy, creating new jobs and lifting depressed household incomes. In a sharp contrast with China’s property overhang, India’s inventory of unsold apartments is near a record low in major cities. Rate cuts next year could start a new cycle of homebuying and construction. That would also give lenders an opportunity to shed a dangerous overreliance on unsecured loans.

Still, it may be imprudent to expect an immediate unleashing of animal spirits. Political uncertainty is high, both globally and at home. Even once the outcome of the US presidential election is known, future American policies and Beijing’s reaction to them will unfold slowly.

Any Chinese response that includes a beggar-thy-neighbor depreciation of the yuan will make it harder for Indian exporters to plan new capacities. Meanwhile, polls this month in the western state of Maharashtra, home to the financial capital of Mumbai, will test Narendra Modi’s hold on power in his third term as prime minister.

As the opposition alliance mounts pressure on Modi’s coalition government, the contest to succeed the 74-year-old leader will heat up within his Hindu right-wing party. Markets can’t expect any consequential economic reforms until the next national election in 2029. The central bank will probably place a strong emphasis on maintaining financial and price stability. And while the federal government seems intent to step up capital expenditure, resource-strapped state administrations might have to pull back on their infrastructure spending. That could weigh further on corporate earnings — and valuations.

Even after the recent selloff, MSCI India trades at 22 times forward earnings, more than 1.5 standard deviations higher the its two-decade average. Chinese stocks are a lot cheaper, by comparison.

The lure of quick riches and the gamification of risky options trading has led to nearly 30 million new client accounts opening at India’s National Stock Exchange in the last eight months, taking the total to 200 million. With retail interest crowding into stocks, the market is still too frothy. During an hour-long special trading session Friday evening, an annual ritual to mark Diwali, auto stocks rose. As did banks and Nestle. It seems local investors desperately want the weakness in the consumer economy to be a temporary blip — caused by heavy rainfall. However, urban growth has been trending down for five quarters.

To borrow a phrase made famous by the late US presidential candidate H. Ross Perot — although in a different context — it may require a deeper price correction before the “giant sucking sound” of foreigners pulling money out changes into the more familiar music of cash pouring in.