Equity outlook: First hope for change in 30 years

The watershed 2014 Indian election has thrown a decisive mandate after 30 years of coalition-based governments. As a result, the new government will have the ability to push through required economic reforms to revive economic growth and contain inflation. However, given the potential risk of a sovereign rating downgrade, the new government cannot be expansive but will instead have to focus on fiscal consolidation in the July Budget.

What is ahead for India?
Now, India has the decisive political mandate to manage macro challenges and sustain healthy growth for longer periods of time. This, we believe, will position India to be an attractive investor destination relative to other emerging markets. Since foreign institutional investments (FIIs) were first permitted into India in 1991, this is the first time a single party has formed a government. FII flows have been contingent on the political environment for policy continuity, despite the structural advantages that India offers in terms of democratic systems, level of transparency, accountability in governance and a reasonably credible regulatory framework. FII flows will likely surpass that of previous years.

The new government will have the option of joining the Reserve Bank of India to fight inflation. On the other hand, it might introduce fiscal consolidation and stimulate investment and consumption demand to revive growth, and avert a sovereign rating downgrade. The government's approach to tackle the challenges that the country is facing is also vital, as its predecessor chose to cut expenditure to meet fiscal targets and, in the process, restricted growth. The new government will need to handle the unfinished reforms started by predecessors, such as allocation of resources like land and minerals and reforms around tax, the financial sector and governance and accountability.

Market driven by renewed optimism
The Nifty is currently trading at 15 times on a 12-month forward earnings basis, against a historical average of 14.2 times. Valuations tend to move ahead of fundamentals with sentiment recovery but the renewed optimism will eventually help recover demand and earnings.

After next week's oath taking, the market's focus will likely shift back on macro factors and global events. Further momentum is expected ahead of the Budget announcement, key in understanding the new government's road map. For now, we expect the momentum to be positive till the end of the year, and the Nifty will likely move up to 8,000 levels (16x forward earnings basis). We believe any market weakness should be used as an opportunity to increase equity allocations for the medium to longer term.

Based on trailing earnings, mid-caps continue to trade at a discount while on forward earnings, they are higher over historical averages. This signals lower earnings expectations, given the prolonged earnings disappointments in the past three years. We expect to see a pick-up in earning revisions in the coming months and this could provide valuation support for price stability.

Export-led sectors could be under pressure in the near term if the domestic currency continues to be strong. Demand drivers for these sectors are promising, though. The infrastructure, capital goods and financial sectors will be in the spotlight with hopes of demand recovery and as their earnings outlook continues to outperform the market.

Lower commodity prices, a drop in labour rates and currency depreciation will help price competitiveness over other countries and potentially recover company profits. In the current earnings season, improvements in the positive surprise factor among large-caps continue for a fourth consecutive quarter; while mid-caps continue their gradual uptick in the positive surprise factor.

Improvements in the operating and financial leverage return ratios will likely recover from current lows and help in re-rating in valuation multiples. The future holds a lot of promise for India.

The author is chief investment officer, India, private banking, The Royal Bank of Scotland