India is entering a cyclical earnings recovery that could see it outperform most emerging markets over the next two years, even as concerns persist around valuations and foreign investor outflows, according to Jonathan Garner, Chief Asia & Emerging Market Strategist and Chairman of Asset Allocation at Morgan Stanley.

Earnings Growth Acceleration Expected

Speaking to ET Now, Garner highlighted that Indian earnings growth has been weaker than widely assumed, creating room for a significant rebound. The Morgan Stanley strategist revealed that broad market earnings growth has been closer to 5.00-7.00% for the Sensex in the year just ended, setting the stage for improvement.

"We now see a cyclical upswing coming, with mid- to high-teens earnings growth over the next two years," Garner said, adding that this would likely exceed earnings growth across emerging markets overall.

Valuation Concerns Ease on Forward Metrics

Addressing concerns that India's growth is already priced in, Garner noted that valuation premiums have narrowed sharply. Based on a two-year forward target of 95,000.00 for the Sensex, Indian equities are trading at around 18.00 times forward earnings, compared with roughly 13.00 times for emerging markets in aggregate.

"At the peak, India was trading at nearly twice EM valuations. That gap has compressed meaningfully," he explained. Despite sustained foreign institutional investor outflows, dedicated emerging market funds are now slightly underweight India—the most negative positioning in nearly a decade, which could set up potential for flow reversals if the earnings cycle turns.

Policy Support and Capex Revival Drive Recovery

Garner attributed the anticipated earnings upswing to multiple domestic factors that are aligning favorably:

• Monetary easing by the Reserve Bank of India
• Improving regulatory conditions
• Early signs of revival in the capital expenditure cycle
• Inflation tracking below 2.00%, creating room for policy support

He acknowledged that nominal GDP growth has been weak despite strong real GDP growth, but emphasized that low inflation provides scope for policy support measures.

Fiscal Position Remains Strong

On fiscal risks ahead of the Union Budget, Garner said India is likely to pursue modest fiscal consolidation, targeting a deficit of around 4.20% of GDP. He described India's macro position as "very strong," citing:

"These factors make India an interesting and relatively resilient story in a very uncertain global environment," Garner noted.

Sector Preferences and Investment Strategy

Within Indian equities, Morgan Stanley maintains an overweight position on financials, industrials and consumer discretionary stocks. Garner highlighted India's young and urbanising population as continuing to support modern consumption patterns, making it "somewhat unique among large global economies."

However, the firm expressed caution on IT services stocks, citing uncertainty around how artificial intelligence adoption could affect traditional revenue models. "IT services is not a sector we are particularly enthusiastic about at this stage," he said.

Within financials, Morgan Stanley prefers private sector banks and non-bank financial companies over PSU banks, highlighting potential for AI-led cost efficiencies to drive profitability. The firm's focus list includes ICICI Bank and Bajaj Finance.

Global Context and Market Positioning

Comparing India with China, Garner noted that China's nominal GDP growth remains weak and lacks clear catalysts for broad cyclical recovery. On commodities, Morgan Stanley remains constructive on gold, driven by rising demand for real assets amid high global debt levels.

While Morgan Stanley has reduced risk exposure after four years of Indian market outperformance, India remains one of the firm's preferred markets for the year ahead, alongside Brazil, the UAE and Singapore. "The key question is whether this cyclical downturn in India—which surprised us in its intensity—now abates and improves. If it does, India should once again stand out within the Asia and emerging market universe," Garner concluded.

The Indian government has announced a major policy reform to enhance foreign participation in the country's defence sector. The foreign direct investment (FDI) limit for defence companies will be increased from 49% to 74% under the automatic approval route, marking a significant liberalisation of investment norms.

Policy Enhancement Details

The revised FDI policy represents a substantial increase in foreign investment allowance for defence firms. The change eliminates the need for government approval for foreign investments up to 74%, streamlining the process for international investors.

Additional Investment Barrier Removal

According to Reuters, other factors discouraging foreign investment in the Defence Sector are expected to be removed. This indicates the government's commitment to comprehensive reform beyond just increasing the FDI ceiling, addressing broader structural impediments that may have deterred international investors.

Investment Route Simplification

The automatic route approval mechanism allows foreign investors to invest up to the specified limit without requiring prior government clearance. This policy change is designed to:

• Reduce bureaucratic processes for foreign investors
• Accelerate investment decisions in defence manufacturing
• Enhance ease of doing business in the defence sector
• Attract international technology and capital
• Remove additional structural barriers to foreign participation

Sector Impact

The increased FDI limit combined with the removal of other discouraging factors is expected to provide defence companies with greater access to foreign capital and technology partnerships. International defence manufacturers will now have enhanced opportunities to establish or expand their presence in the Indian market through increased ownership stakes in local defence firms.

This comprehensive policy revision aligns with India's broader strategy to strengthen domestic defence manufacturing capabilities while encouraging foreign investment and technology transfer in the sector.