Don't expect large downside from here

A significant risk in the near-term would be foreign institutional investment pulling out of the Indian market. The last three months have seen FIIs divesting close to Rs 20,000 cr

The Indian markets are at a juncture of economic adjustment that is taking place both on the global and domestic front. The Reserve Bank of India's liquidity tightening measures to arrest currency volatility in mid-July resulted in an increase in interest rates. More, early signs of US Quantitative Easing tapering caused a stir amongst emerging markets (India and others) as money started to unwind back to US shores. The US 10-year treasury yields are now trading at 2.85 per cent, which in early May were close to 1.3 per cent. The rise in US treasury pushed up cost of capital for other countries.

The other concern in the current environment is India's current account deficit (CAD). At $70-90 billion, our CAD is poised to be amongst the largest three in the world. India cannot continue to rely on foreign capital flows to finance its external deficits forever. Our exports have to rise to fill the shortfall, implying the gap between the savings and investments must close, by increasing savings.

However, recent developments like the government's push to clear the food security Bill only encourages consumption and further impacts government finances - in its current state, it would be challenging to maintain our fiscal deficit targets. The recent pain in the equity markets only reflect the economic and regulatory developments around us. A significant risk in the near term would be foreign institutional investment (FIIs) pulling out of the Indian market. The last three months have seen FIIs divesting close to Rs 20,000 crore.

Their net investment, however, still remains positive at Rs 61,000 crore in 2013 . The current mix of benign growth, governance challenges and depreciating currency, coupled with a stronger growth in developed market, increases risk of capital outflow.

In terms of sectoral performance, the banking and financial sector has been the worst hit from the recent policy changes. The banking sector now faces challenges on margin front, credit growth (given we have a slowing economic growth) and asset quality- which tends to accentuate during slower economic environment. On year-to-date basis the Bankex Index has underperformed the BSE200 by 17 per cent. The information technology sector witnessed strong gain even during the recent market contraction showing there are pockets of outperformance.

We believe the recent market correction has built in most of the concern. It isn't however all gloom . The currency depreciation for example, improves the competitiveness of our exports and incentivises import substitution.

A reasonable proportion of Sensex companies are net exporters or producers of tradable goods and stand to gain from the weak currency. In our view the markets are likely to move in a broad range over the next year. Currently, while we don't see triggers for market upside, however we don't expect large downside either given that valuations have come down to attractive levels.

Second, we have started witnessing weakness in good quality names which generally indicates capitulation phase in markets. Clarity on election and governance along with some bold policy moves can alter the dynamics positively.

We advise investors to remain cautious and look for opportunities to systematically invest in quality businesses that are available at a bargain.

The author is Co-Chief Investment Officer, Birla Sun Life AMC