The ride will not be easy

The biggest risks to optimistic outlook (aside from the risk of a Euro zone train wreck) are a sovereign credit downgrade or govt instability

After a near 25 per cent rise in the Nifty this year, making India one of the best performing markets in the world, the natural question is how much further the rally has to run. I see a much more constructive outlook for Indian equities, with probably another 15-20 per cent upside on a 12-month view, driven by a turn in the earnings cycle, rate cuts, and the investment cycle showing signs of life. But the rise is unlikely to be a linear one, so investors shouldn’t lose valuation discipline and only add quality beta.

The biggest risks to that more optimistic outlook (aside from the perennial tail risk of a Euro zone train wreck), are a sovereign credit downgrade or government instability. India’s credit rating downgrade (to sub investment grade) has been postponed by recent government moves but the threat remains real until there’s considerably more progress on fiscal consolidation and the country’s political score on rating agency metrics.

Parliamentary arithmetic supports government stability, and the prime minister and finance minister are betting that with the BJP squabbling over leadership issues and other opposition parties facing their own challenges, they won’t try and bring down the government over new reforms.

That doesn’t mean an easy ride. The government faces a tough test over the coming weeks, notably with the winter session of Parliament starting on November 22. The monsoon session of 2012 was the worst since winter 2010, with only four bills passed versus 30 planned. Given several controversial reforms introduced between the monsoon and winter sessions, the odds are high that it will be another severely disrupted session. The risk is that market sentiment takes a hit in the face of any disruption, possibly offering better buying opportunities.

Turning to corporate earnings, so far Q2 has been inline or marginally ahead of estimates, leading to a marginal 0.3 per cent upgrade in October to consensus estimates for CY13 earnings per share for the BSE 100 Index. So, a very slight upward bias in aggregate earnings after Q2 is constructive for the market and provides some support post the reform-led rally. Though, I’d stress that we see evidence of stabilisation in corporate results, as in GDP numbers, not the beginnings of an upgrade cycle.

Regarding rates, my best guess is a repo rate cut of 50 basis points in the fourth quarter, and for gradual rate cuts to continue in FY14. However, there is a risk that the Reserve Bank of India (RBI) continues its hawkish stance, given inflation is unlikely to move below its target level anytime soon. Hence, it might choose to continue to focus on liquidity management through other tools. RBI chief D Subbarao did at least state last week that easing could be possible in January.

Sector-wise, we continue to focus on banks (though highly selectively among public sector banks) and financials, quality capital goods and infrastructure names to play the incipient recovery in the investment cycle, pharma, notably Lupin and Cipla, and mid-cap information technology services, where we like Persistent Systems and KPIT Cummins. We’re underweight consumer, where stocks are expensive and discretionary categories are starting to suffer, with Q2 seeing some companies missing volume estimates.

The author is country head, India, Espírito Santo Securities