Equity Outlook: Valuations dampen risk-reward outlook

Globally, appetite for risk has improved, especially towards emerging markets including India

In our view, the near-term outlook for the market, post the move up over last month, is no longer positive, as current valuations make risk-reward scenarios unattractive. Let's look at the key factors for markets ahead.

Globally, the appetite for risk has improved, especially towards emerging markets, including India, and it is likely to continue to play a key role in near-term performance.

However, notwithstanding the uncertainty as to timing, investors continue to worry about the impending tapering of quantitative easing. While we do not expect tapering to create a currency crisis for India, given the funding structure and the country's reduced current account deficit (CAD), it is likely to depress investor sentiment.

The improvement in the CAD has boosted sentiment but is, to a large extent, cyclical rather than structural. Near-term, global risk appetite appears to be supportive for Indian markets but many global macro market indicators also imply that much of the good news could already be priced in from an emerging market perspective.

Local macro fundamentals have been positive over the last couple of months and one of the best monsoons in recent years is a positive and has created hope among investors. Bumper crops are expected, which implies strong growth for the rural economy but, overall, the impact of the macroeconomy might be limited, as agriculture accounts for just 14 per cent of GDP. The outlook for both, the macro-economy and growth, remains weak.

At the same time, fiscal slippage continues to cast a shadow, although the signs are that investors are becoming complacent. The government's fiscal deficit target of 4.8 per cent of GDP implies there are spending cuts ahead, despite the impending elections. Ironically, a lot of the fiscal spending is largely on rural India and any cuts have the potential to undermine the boost given by the relatively benign monsoon. The vicious cycle between slowing growth and fiscal consolidation remains in place. If the government abandons fiscal discipline, then resultant sticky or higher inflation might imply negative real wages, even for rural India, casting doubt over the prospects for a sustainable recovery.

RBI’s focus on inflation bodes well for long term fundamentals, while its tapering of tightening will boost sentiment in the near term. However, the investment cycle remains a key factor in correcting India's economic imbalances and progress remains uncertain. Key ingredients for any recovery including fiscal consolidation, policy stabilisation and marginally improving support from the government, should not be completely ignored.

While Q2 (September quarter) earnings, which reflected margin discipline by companies and the effects of a lower base rate, were a positive surprise, the outlook for earnings remains muted.

Politics will hold sway over India's markets both in the near term and over the next three quarters. Based on our discussions with investors, markets are positively inclined towards the Narendra Modi-led Bharatiya Janata Party, but less so towards the Congress, despite its recent policy adjustments. Markets worry about a potential Third Front government, given increasing fragmented polity, but history suggests such a dispensation can also deliver in terms of policymaking.

Our view remains that any new government, post-elections, is more likely to take steps to course-correct the economy. Based on 15 times FY15 estimated PE, assuming 15 per cent earnings growth in FY15, the Nifty could reach 6,800 in the second half of 2014, following the elections. This also implies limited upside from current levels, while downside from potential negative catalysts still remain. Near-term volatility is also likely increase as the elections loom. We view the risk-reward to buy as attractive below Nifty 5,500 levels.

The author is head of India research, UBS Securities India