Equity outlook: Fairly valued at this juncture

The markets have already started factoring in a favourable election outcome, even as seat calculus remains uncertain. Cyclical sectors such as infrastructure and banking have outperformed the defensives like information technology (IT) and pharmaceuticals in the past few weeks.

The rally is almost entirely driven by foreign institutional investors (FIIs), who seem to have greater confidence in the election outcome than domestic institutional investors, which had been net sellers. While there are reasons to believe the outcome can further support the valuation expansion and take markets to new highs, the earnings growth scenario is unlikely to change meaningfully in the near term.

The earnings Revisions Index also continues to point towards downgrades. In a base case scenario of 10 per cent earnings growth for next year, the markets look fairly valued at current levels and unless the earnings trajectory changes significantly, the near-term valuation expansion is unlikely to be sustained over time.

FII ownership in most companies is already at an all-time high, while domestic institutions have progressively lost share due to minimal participation by households, whose share of the market has come off to 7.6 per cent from 15 per cent in 2002. The accelerated US Federal Reserves tapering and improving developed market fundamentals could see more allocation in these over emerging markets (EM) in future. While India seems better poised among EMs, because of a stable currency and growing reserves, a continued fall in trade deficit, along with a decisive mandate in the Centre, is critical to sustain global flows.

On the economic front, while growth seems to have bottomed, recovery could be a long drawn a process and gross domestic product (GDP) growth is expected to marginally recover to 5.3 per cent in the next financial year, from 4.7 per cent in FY14.

Service sector growth, that fell to its lowest level in 12 years, is unlikely to turn around meaningfully in the near term. Agriculture growth could see mean reversion as chances of a below normal rainfall have risen on account of the emergence of the El Niño phenomenon. The only silver lining could be revival of investment cycle as policy bottlenecks get cleared and capacity utilisation improves for industries operating way below the historical peaks.

Inflation numbers - both the Wholesale Price Index and Consumer Price Index - have come off meaningfully driven by lower food and fuel inflation. However, core inflation continues to remain sticky. The Reserve Bank of India is likely to maintain a pause in its next policy meeting and is not expected to reverse its anti-inflationary stance. Overall, growth revival is going to be stretched with inflation as the key overhang but FY15 still looks better than FY14, on both counts.

On the currency front, while we see near-term stability, forward premiums clearly suggest dollar strengthening on one the hand and potentially peaking budget oversight and performance on the other. Also the US taper headwinds and rise in import growth are expected to keep the rupee under pressure from a medium-term perspective. Having said that, the downside risk to the currency is limited given the comfortable outlook for the CAD for FY15.

Given the heightened uncertainty in the near term, there is a strong case to favour a quality-conscious portfolio through sectors like IT and pharma that will continue to benefit from global demand and dollar revenues. In the current rally, private sector banks with low non-performing assets and select capital goods look more promising than pure-beta play through sectors such as public sector banks, infrastructure, metal and real estate.

The author is senior vice-president & head, investment advisory & family office, Religare Private Wealth Management