India set to become the largest EM: Is this Good or Bad News?

Investing.com -- India's recent rise to become the largest weighting in the MSCI Emerging Markets (EM) Investable Market Index (IMI (LON:IMI)), surpassing China, represents a key milestone in the global financial landscape. This development prompts the question: is this positive or negative for Indian equities?

A rising weight in the MSCI EM index signals increased attention from global investors, which is particularly beneficial for India. As India overtakes China to become the largest component of the MSCI EM IMI index, it is poised to attract more foreign portfolio flows.

This is largely because many global investors who follow these indices will need to increase their exposure to Indian equities to match the new index composition.

India's current underweight position in the average EM portfolio further amplifies the potential for foreign inflows. Historically, Indian equities have been underrepresented in global emerging market portfolios, but as its weight increases, foreign investors will likely adjust their portfolios accordingly.

This adjustment, coupled with India's near 2% weight in the global index, means that India is no longer merely a tracking error in global portfolios; instead, it has become a major component that cannot be ignored. As a result, global funds may need to buy Indian exchange-traded funds (ETFs) or directly invest in Indian stocks.

However, there is a challenge as domestic investors in India have been outbidding foreign investors, making it harder for foreign portfolio flows to establish a strong presence.

This flags the importance of expanding the issuance pipeline, which could supply the needed opportunities for foreign investors. Morgan Stanley (NYSE:MS) analysts expect this to result in more foreign participation in the Indian market in the coming months.

While a rising index weight is generally positive, it can also be a warning sign of market exuberance. Rapidly increasing market weights can sometimes precede periods of underperformance, as seen in the case of China.

“However, China continued to ascend in weight terms and recovered in performance (both absolute and relative) only to peak much later (in Oct-20) after its rise to the top in 2008,” said analysts from Morgan Stanley.

While India’s situation is not identical to China's, the historical precedent suggests caution. The rise in India's index weight could reflect improving fundamentals, such as a larger free float and rising relative earnings, which are positive indicators.

However, it is also essential to recognize that these factors do not guarantee immunity from short-term market corrections, especially in a bull market that has shown signs of strength for an extended period.

Morgan Stanley analysts note that India’s growing share in global GDP and the global market is a positive long-term trend, provided corporate earnings remain strong. However, they also caution that a correction in the Indian stock market may be on the horizon, driven by investor concerns and market dynamics.

Despite the potential for short-term corrections, India remains a top pick among emerging markets, according to Morgan Stanley. The country’s economic fundamentals, coupled with its rising weight in global indices, make it an attractive destination for long-term investors.

In the Asia-Pacific context, India is Morgan Stanley's second preference after Japan, highlighting its importance in the region's investment landscape.

The potential for a correction in Indian equities could present a buying opportunity for investors who have been waiting on the sidelines.

Morgan Stanley analysts believe that any market corrections are likely to be mild, as they may attract more investors looking to take advantage of lower prices.

This implies that while the peak of the bull market might still be ahead, India's weight in the EM index could keep increasing before it reaches its highest point.

This article first appeared in Investing.com