Could India be a hedge for U.S. recession?

This report is from this week’s CNBC’s “Inside India” newsletter which brings you timely, insightful news and market commentary on the emerging powerhouse and the big businesses behind its meteoric rise. Like what you see? You can subscribe here.

A surprise interest rate hike from the Bank of Japan and the Federal Reserve’s willingness to put a September rate cut “on the table” put global stock markets on the brink.

Then came a disappointing U.S. employment report that ultimately pushed stocks off their cliff and spoilt the party for investors.

Taking stock of current economic conditions worldwide could partly address that question. While Europe is struggling and China is slowing down, India is booming.

Such a disconnected global economic picture means “it is unlikely that a macroeconomic distress in the U.S. becomes a global event in 2025,” Venugopal Garre, head of India research at Bernstein, told clients this week. Bank failures in the U.S. and Europe in 2023 and China’s multi-year housing slump provide evidence of the impact of significant shocks being localized rather than allowed to spread worldwide.

Historically, a U.S.-led recession typically leads to fund flows into safe-haven assets, such as U.S. dollars, Treasurys and gold. In contrast, risk assets like stocks and emerging market currencies fall. A depreciating Indian rupee, which hit an all-time low this week against the greenback, would dent total returns in U.S. dollars, euros or sterling, as the case may be for foreign investors.

However, the interest rate differential created by the Reserve Bank of India’s decision this week to hold interest rates at 6.5% while inflation continues to edge lower amid strong GDP growth might help temper the severity of a rupee sell-off, according to Garre.

The rupee might also benefit partly from a U.S. recession if commodity prices tumble. As a net energy importer, India is highly sensitive to crude oil prices. A U.S. recession that lowers Brent crude oil prices might help prop up the Indian currency.

More broadly, the Indian economy is also consumer driven, unlike China’s and Japan’s reliance on exports. Data shows that the U.S. is not a major destination for Indian manufactured exports. Services such as those in IT and business process outsourcing, which accounts for 75% of exports, are unlikely to become uncompetitive suddenly.

“The fundamentals of the economy don’t change — even when the U.S. enters a recession,” Bernstein’s Garre said. “Hence, a short term correction … does not necessarily create the case of a longer fallout and we see limited risks from a U.S. recession — if it plays out that is.”

Elsewhere, the Indian government — after Prime Minister Narendra Modi took a significant hit in the general election — has also taken steps to mature the economy. Investors have welcomed the lower budget deficit forecast and self-imposed constraints in the latest spending pledges, which could help push stock prices higher.

“Eventually, India is likely to head into primary balance which supports a new high for corporate leverage, private investments and share of profits in GDP,” said Morgan Stanley’s equity strategist Ridham Desai in a note to clients this month.

“The consequent rise in share prices will also be supplemented by a further increase in the equity allocation on household balance sheets, significant global allocations to Indian stocks (reflecting India’s rising index weight) a rise in corporate issuances and a new peak in equity valuations.”

However, not everyone subscribes to the view that India could be used as a hedge if the U.S. falls into a recession.

“I wouldn’t say that India is going to be completely detached, but I think that India is in a much better position to ride through the volatility noise,” John Ewart, a portfolio manager behind Aubrey Capital’s $600 million Global Emerging Markets fund, told CNBC’s Inside India. More than half of Ewart’s fund is invested in India.

“Companies that we’re looking at are insulated from the short-term noise that we see and read, which emanates from speculation as to what the next U.S. Fed rate cut may be, and when, or what’s happening to the Japanese yen,” Ewart added. His fund’s top holdings are Varun Beverages — a distributor of Pepsi, food delivery company Zomato, and real-estate developer Macrotech.

In fact, “the enemy lies within” for Indian equities, according to Bernstein’s Garre. A key risk for investors is the lofty valuations for stocks in the current climate. Indian equities continue to create all-time highs even after analysts downgraded earnings expectations by 1% for nearly half the 200 largest Indian companies.

The strategist pointed out that despite a two-day intense sell-off, Indian equities continue to have “rich valuations and lack of earnings support.”

India’s Nifty 50 is now outperforming the S&P 500. As mentioned above, the benchmark has surged 11.8% so far this year, outpacing the S&P 500′s 9% gain, and analysts have told CNBC that the index could go even higher. Traders increasingly expect the U.S. Federal Reserve to cut interest rates in September, and that environment could boost Indian stocks.

Indian stocks have fallen 2.4% this week alongside global peers. The Nifty 50 index has stayed above 24,000 points after hitting 25,000 for the first time last week. The index has risen 11% this year.