On the global financial stage, the Indian stock market has recently made headlines due to a significant downturn, likened to a seismic event shaking investor confidenceThe turmoil reached alarming levels on Tuesday when the market saw its largest drop in four years, plummeting by nearly 8% at one point during tradingHowever, a rebound was witnessed the following day, with the SENSEX index recovering over 3%, yet the remnants of investor anxiety lingered in the air, primarily fueled by concerns over high valuations within the market.

Despite the recent turbulence, many international investors maintain an optimistic view on the long-term prospects of the Indian stock marketHaresh Sharma, the institutional portfolio manager of Franklin Templeton’s emerging markets equity team, expressed this sentiment, highlighting that India's share in the global GDP has grown impressively — from a mere 1.1% in 1993 to close to 3.5% now

The performance of the Indian stock market is strongly linked to the nation’s economic growth, which is among the highest correlations seen in emerging marketsHe noted that increased income levels and a burgeoning young population are set to drive consumption, supported by structural reforms implemented over the past decade that have strengthened governance and boosted investment.

On Tuesday, market indices faced a notorious downturn, with the Nifty and SENSEX indices both plunging by 8%, marking a notable low since JanuaryAt the close of trading, the Nifty posted a drop of 5.93%, concluding at 21,884.50 points, while the SENSEX fell by 5.74% to close at 72,079.05 points, reflecting the largest drop since May 4, 2020. Additionally, small-cap stocks faced significant corrections of about 8%, with a majority of cyclical sectors suffering declines of 10% to 15%. Just a day earlier, the SENSEX had reached a historic high of 76,468.78 points, underscoring the abrupt shift in market sentiment.

In the aftermath of such a dramatic plummet, signs of recovery began to appear, although institutional investors remain cautious

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According to a representative from a local Indian investment firm, the markets might continue to exhibit volatility until certain critical issues regarding governance are settledThis perspective points to a lingering uncertainty following the unexpected loss of a parliamentary majority by the ruling Bharatiya Janata Party (BJP) in recent elections, prompting a keen focus on the formation of the new government and the composition of its cabinet.

Financial analysts from Barclays noted that after the BJP "shockingly lost its majority," eyes are turned towards the cabinet appointments under Prime Minister Modi’s leadershipWhile the BJP retained a significant presence as the largest party, it will now navigate the complexities of coalition governance to demonstrate effective leadership ahead of Modi's anticipated swearing-in for a third term on June 8.

In light of the BJP’s loss of a parliamentary majority, experts observe substantial progress made in India towards achieving macroeconomic stability in recent years

This includes enhancements in managing current account deficits, maintaining inflation within targets set by the Reserve Bank of India (RBI), and reducing fiscal deficitsWhile concerns about the impact of reduced majorities on these gains are palpable, the general consensus among market analysts remains that such effects may be limited in scope.

Goldman Sachs highlighted the fact that this marks the first time in a decade that the BJP has not secured an outright majority in the lower houseThe main challenges ahead involve managing coalition partners, who may seek roles for their members in key ministries, potentially complicating the process of enacting structural reforms essential for economic growthSuch endeavors may include land reforms to bolster manufacturing and agricultural productivity improvements.

With valuations deemed excessively high at present, many investment firms are pointing to overpriced market conditions as a core reason for the recent major declines

Nevertheless, some analysts believe that once the dust settles, the potential for investor returns will entice them back into the marketLiu Mingdi, Chief Asia & China Equity Strategist at JPMorgan, remarked that historically, investor interest piques when Indian stocks are valued at P/E ratios between 17 and 18. Though the current P/E ratio hovers around 22, he asserts that the underlying appeal of mid-term structural growth remains compelling enough for renewed interest.

Even while acknowledging that a P/E ratio of 22 is not particularly cheap, Goldman Sachs insists that India's strong earnings trajectory remains resilient, with a reported earnings growth of 20% last year and a 16% increase in the first quarter, surpassing expectationsForecasts suggest an average annual growth rate of 15% for earnings in 2024 and 2025, which should underpin favorable returns for investorsWith significant capital inflows lagging this year, there is an anticipation of foreign investors returning to the market.

Indeed, despite volatility, the Indian stock market has been among the best-performing globally for the past several years

According to multiple international asset management firms, there exists a narrative that paints India as a persistently expensive marketFranklin Templeton noted that from three years prior to April this year, the MSCI India Index yielded about a 12.5% annual return in USD terms, in stark contrast to an 8% drop in the MSCI Emerging Markets Index and a mere 2% growth in the MSCI World Index.

This remarkable performance is not merely a fleeting occurrence but represents a consistent upward trend that has persisted for a decade and even mirrors a broader historical advancement of nearly 30 yearsSince the end of May 1994, the MSCI India Index has generated a staggering 66.6% return, in juxtaposition to a mere 5.4% for the MSCI World Index and 2.5% for the MSCI Emerging Markets IndexSharma asserts that this long-term success can be traced back to India's impressive GDP growth.

The significance of this rise in GDP share, escalating from 1.1% in 1993 to around 3.5% today, emphasizes that India's ascendance is not merely a flash in the pan but a result of accumulated progress over time

Some analysts project that India could potentially surpass Germany and Japan to emerge as the world’s third-largest economy, underscoring the trend of stock market performance that closely correlates with economic development.

Sharma elucidated that several catalyst factors have prompted international investors to increase their stake in the Indian marketA crucial driver has been the anticipated rise in income, where urban per capita income is expected to reach $3,000 by 2025, enhancing consumer purchasing abilityAdditionally, the narrative of structural reforms gaining traction, with improvements in government spending efficiency, operational governance and better business conditions, cannot be overlookedFurthermore, the digital transformation currently in full swing, exemplified by initiatives such as the “India Stack” — an umbrella term for the digital public infrastructure encompassing identity, payment, and data layers — invigorates prospects for growth.

Manufacturing upgrades have also captured global attention, bolstered by initiatives like the Production Linked Incentive (PLI) scheme and the ongoing trend of supply chain diversification

Furthermore, India's evolving "consumption story" has caught the eye of many, with expectations that affluent and middle-class demographics will swell to 400 million in number, marking a notable shift in consumer categories towards high-end markets, a relatively sparse segment in the current landscape.

However, despite the positive projections, Sharma mentioned that India's manufacturing sector contributes only around 13% to the GDP, in contrast to markets like China, Vietnam, and Bangladesh, where contributions hover closer to the 20-30% range.

The ongoing transition of India’s vast population into a demographic dividend remains a critical focal point for various stakeholdersWith a median age of just 28, the youthful population necessitates substantial employment solutionsInsights from Fortune Investments note that prior to the sudden emergence of the "population superpower" narrative, demographic structure was never a necessary or sufficient condition for economic advancement

Over the years, India has wrestled with the challenge of high unemployment amid growthAs the nation enters an era of automation and artificial intelligence, creating viable job opportunities for a burgeoning population presents an escalating challenge.

Interestingly, in the context of the MSCI Emerging Markets Index, India, alongside Korea and the Chinese stock markets — encompassing A-shares, Hong Kong stocks and U.Slisted Chinese firms — plays a pivotal role in influencing market dynamics and fund flows across the spectrum of emerging markets.

Recent shifts reveal that some foreign institutional investors have recently pivoted their investments away from Indian equities towards China, citing that Indian stocks had exceeded a P/E ratio of 21, while China’s MSCI index was below 8 prior to any rebound and is now only just surpassing 10.

Since late May, the Chinese markets also faced corrections, and many overseas long-term capital sources have yet to follow flows into the Chinese market in tune with quantitative and hedge funds