Equity outlook: Indian markets set for new highs

Barring the two events of elections and the Fed taper, the markets are well poised to show gradual improvement.

In 2013, Indian markets delivered returns worth nine per cent, with the entire gains clocked in the last quarter of the calendar year. Foreign institutional investors (FIIs) invested $20 billion in 2013, making it the third biggest year of inflows.

On the other hand, domestic investors withdrew a record $13 billion. The beginning of this year has seen some pullback as emerging markets (EMs) remain less preferred over developed markets.

Valuations of Indian equities are attractive with market cap to gross domestic product at 60 per cent below long-term averages.

The Sensex price to equity (P/E) at 13.5 times is also below long-term averages, while the returns on equity have seen their bottom. We expect 2014 to see improvement in growth rates and moderation in inflation, leading to another year of positive returns for Indian equities.

Our positive view on equities is based on the following three arguments.

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A crisis causes its own conquest. India faced a crisis of the eerie combination of low growth, high inflation and external instability.

Since Raghuram Rajan assumed the role of Reserve Bank of India (RBI) governor, the approach on various policy measures have seen a significant shift.

This has brought in the much needed stability in aspects of policy rates and rupee. Fall in inflation in recent months have exceeded estimates and will drive stability in monetary policy.

The trade data for recent months also show the big concern of current account deficit is now surely behind us. Growth prospects in West will aid exports in 2014, while imports will remain muted due to domestic slowdown and commodity prices.

RBI has used this phase to build forex reserves close to $300 billion. The fiscal consolidation process has begun with deficit estimated at 4.1 per cent in FY15. The twin deficit phase is not concerning any more.

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Second, the earnings growth of corporate India is slowly recovering to the mean of 14-15 per cent.

The third quarter earnings of 2013-14 grew around 14 per cent and we expect same to sustain in 2014-15.

Downgrades to the Sensex earnings per share (EPS) have taken a breather. In fact, we have seen upgrades of four per cent in FY14 and three per cent in FY15 EPS since September.

Of course, this is largely led by offshore business models such as IT, health care, etc. However, we expect many of the domestic models to show moderate recovery in FY15. Earnings growth will remain the most critical driver of any recovery in markets.

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Last, a churn is taking place in India and the 2014 mandate will reflect this ‘manthan’!. Recent opinion polls clearly indicate a strong anti-incumbency wave against the UPA government.

In the Assembly polls of December, the decisive mandate saw BJP, riding on the NaMo wave, forming government in three out of five states with record number of votes.

Development and governance are the key points in most elections, with strong mandates against corruption.

With two months remaining for Lok Sabha elections, a lot of action is expected on the political front which is likely to keep markets volatile and the environment uncertain.

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The key risk in 2014 would largely be from global trends. The US Federal Reserve recently announced the second round of tapering of its stimulus package, after a period of over five years of easing.

During this period, India received $109 billion, in aggregate, $91 billion from equity and $18 billion from debt. The impact of tapering is clearly visible on the debt front with $12 billion outflows in the seven months, since the talks of Fed taper first started.

Accordingly, out of the total debt flows of $20 billion received since November 2008, 40 per cent of the cumulative debt flows ($8 billion) was withdrawn by investors in calendar year 2013 (CY13) alone.

Equity flows, on the other hand, continue unabated with CY13 receiving $20 billion (third highest equity flow ever). With the Fed taper, India could see moderation in the flows.

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Barring the two events of elections and the Fed taper, the markets are well poised to show gradual improvement.

Equities have been almost flat since January 2008, while earnings have almost doubled since then.

As an asset class, the risk to reward ratio has surely got favourable and we would recommend investors to consider raising exposure to equities.

Rajat Rajgarhia is managing director, institutional equities, Motilal Oswal Securities