Markets 'May' just get better

After the euphoria of December 2013, some sanity has set into the market. The market seems to be taking a breather, with the initial weeks of January being rather subdued. The earnings season is underway and the first signs have been encouraging, beginning with Infosys. Better operating and financial leverage will aid a recovery in net profit margins, although the fuller impact of the recovery will reflect in earnings with a lag. We believe the earnings downgrade cycle is behind us and current consensus FY15/FY16 earnings estimates will see upgrades.

Most macro variables, including economic growth and current account deficit, are set to improve. Though the Index of Industrial Production numbers continue to remain depressed. With inflationary trends on an incremental basis in the economy showing signs of peaking, interest rate reversal cycle may not be far away, if not the next quarter it will definitely take place within the next six months.

The big event remains the elections, to be held by May. The election commissioner has already said the dates will be announced before the end of February. Around that time, we will have the vote-on-account and after that, the entire market will keep a close eye on the ballot box or political developments, rather than the performance of corporate India.

We believe FY15 will be a watershed year and will herald the beginning of a broad-based market rally for equities. The agricultural and rural economy are doing well on the back of decent monsoons.

In FY15, as the overall economy revives, private-sector capex will re-start with a lag of 12-24 months. Quality of growth will be better as recovery will be led by a turnaround in investment cycle.

The big unknown at this point is elections. In December, most people appeared confident of the Bharatiya Janata Party (BJP)-led National Democratic Alliance coming to power at the Centre. However, developments in Delhi following government formation by the Aam Aadmi Party (AAP) has given a twist to the tale and made the political situation less predictable. So long as we get a stable government at the Centre - whether BJP-led, Congress-led or even an alternative to the main parties - the market will take it in its stride.

The government of the day will have no choice but to get its acts together soon to ensure macro economical parameters are back on track. So, independent of which government reigns at the Centre, the focus will be on addressing key issues such as infrastructure, power, roads, natural resources like coal and gas, and goods and services tax, among others. Investors, meanwhile, will adjust to a new normal. The government of the day will be forced to take decisions, good for the economy because job-led economic growth and not subsidies is what the electorate will demand. To put things in perspective, the best years of reforms were in the early 1990s when a Congress-led government and early 2000 when a BJP-led government ruled.

Market valuations have seen a de-rating over the past three years; large-cap indices such as the Nifty are still trading close to the historic median whereas mid-small caps are trading at much lower than median levels, especially on a price-to-book basis. The reason is that earnings downgrades have been much more severe for mid-small caps.

Now, as macro variables start to look up, the earnings outlook will start to improve and recovery for mid- and small- caps will, therefore, be sharper. Our mid-cap buys are Crompton Greaves, Ramco Systems and Shriram Transport. The top large-cap buys are Dr. Reddy's, ICICI Bank, L&T, Wipro and Hero MotoCorp.

The outcome of the May general election can potentially be a market-moving event. Whether we get a stable government or not is the question. For that, we will have to wait and watch.

The author is managing director, IIFL