Indian equities exemplify the expensive quality trade within emerging markets over the past couple of years. Despite high expectations, Indian companies have failed to generate persuasive improvements in their capital expenditures/sales ratio or in asset utilization. As a result, investors have pushed multiples for many Indian equities higher in spite of muted tangible improvement in corporate profits. Exhibit 1 illustrates the aggressive implied growth rate being factored into the India story. In contrast, Chinese assumptions remain fairly tepid and more realistic.

Exhibit 1: Growth in Perpetuity by Current Market Price

NTM stands for next 12 months and STM stands for second 12 months. Source: IBES, MSCI, Citi Research

According to Bloomberg data, India remains a consensus overweight among EM portfolio managers, while nearly 40% of US-domiciled EM funds are at least 50% underweight China. Despite its dramatic rally, investor interest in Chinese equities appears to have only started to grow, as suggested by the recent uptick in share creation of the iShares China Large-Cap Index.

Investors must remain aware of the potential effect of unraveling “herd trades” in emerging markets and other asset classes. With plenty of liquidity and low volatility, many investors have been lulled into a false sense of complacency, but the golden period of weak growth and ample liquidity may be drawing to a close. Investors with aggressive allocations to expensive higher-quality growth companies may find themselves facing pain-trade scenarios, such as in the autumn of 2014 when investors were similarly left choosing between China and India.