Invest cautiously before elections

Stay invested in bank fixed deposits till the election and then take a call on equities

As an incurable cynic, I tend to assume that all Budgetary projections are optimistic and as such, very unlikely to be met. This is especially likely to be true in an election year when the Budget is a valedictory exercise rather than an attempt at serious fund allocation.

A quick look at the past 15 years suggests four out of five Budgets are optimistic and one out of five understates growth. It is an useful exercise therefore, to assume that the Interim Budgetary assumptions put a ceiling on likely growth.

So India's GDP growth next fiscal will be somewhat less than the 6 per cent implied in the Budget. The fiscal deficit will probably teeter on the edge of 5 per cent of GDP. Inflation may come down to the levels targeted by the RBI and the Current Account Deficit is likely to stay in the range of $50 billion. The tax buoyancy will be less than the assumed 19 per cent.

On the excise and tax front, the Budget cuts duties across a fairly wide range of consumer durables and automobiles. Those cuts are being passed on and may just lead to a stimulation of consumer demand, which would be useful.

Beyond this, there isn't much to be said about the Budget, good or bad. Assuming the RBI assumptions are correct about inflation levelling off, 2014-15 could be an average to good year. Business activity will improve significantly but not by an extraordinary degree.

If the supposedly business-friendly BJP comes to power with a stable NDA coalition there should be some investor enthusiasm. This might cause an asset bubble with share prices going through the roof soon after the new government is installed.

If there's a shaky coalition, as is more likely, or a hung parliament, which is not impossible, investment would dry up. In that case, there would also be a significant chance of India receiving sovereign rating downgrades from credit rating agencies. The market would likely see a deep correction in those circumstances.

In theory, the investor has an easy bet in these circumstances. He can allocate a probability to each of these cases, and figure out the likely risk or reward and then evaluate the best bet. For example, let's say the investor believes there is a 35 per cent chance of the NDA putting together a stable coalition and he assumes that the stock market will rise 30 per cent in that case. He also believes there is a 35 per cent chance of a shaky coalition when the market will fall by 30 per cent. Further, he believes there's a 30 per cent of a hung verdict and the market could fall 50 per cent if that triggered a downgrade.

If those are his assumptions, he projects equal gains and equal losses one-third of the time by being heavily invested. He expects a large loss 30 per cent of the time. In fact, on balance he expects to lose around 15 per cent by going long. He expects to make 15 per cent by going short (actually less due to the cumbersome nature of short positions).

The probability assumptions given above are just random numbers. In reality, the investor has to make a judgement call about electoral probability. He also has to make an assumption of the likely returns associated with each electoral outcome. His projections will inevitably be coloured by his political and economic biases.

There is another consideration. India has been in recession for roughly three years. Valuations are not very high. Even if there's a deep correction, it could present a buying opportunity. Sooner or later, even given political mismanagement, the economy is likely to turn around. It is common sense to want to have a foothold in the market under the circumstances.

Most importantly, the investor doesn't have very attractive alternatives. Interest rates remain high and while they may eventually reduce, the RBI's hawkish stance makes debt-funds look risky. Real estate is in poor shape with all the majors cash-strapped, and excess capacity which could translate into sharp falls. Gold looks a poor gamble - if the global economy is recovering, precious metals will lose ground.

The old formula of short-term fixed deposits and staggered equity investment comes into play. Stay in FDs till the election and then take a call on equity. If the NDA comes in with a bang, a big short-term exposure to equity may pay off. If there's a different outcome, you may want to invest slowly, taking advantage of every fall in the market.