Markets could correct this year

A 20-30 per cent correction is likely while the upside is limited to 10 per cent

Macro-economic data flow last week indicated a big rebound is not around the corner. The Index of Industrial Production has, however, moved into positive territory after several months of stagnation. A gain of 2.4 per cent year-on-year in January 2013 versus January 2012 is no great shakes. But it is a positive signal even if it isn't high-decibel.

Allied to positive export growth after 10 months, the IIP suggests things are improving. The HSBC Purchasing Managers Index (PMI) also remains above 50, which implies economic expansion continues, albeit slowly.

Balanced against this, inflation data is worrying. Consumer Inflation remains above 10 per cent. It's driven by high food prices, which contribute about 47 per cent by weight of the CPI indices. The WPI is up 6.85 per cent, because food inflation (with a weight of about 14 per cent) has also had some impact there. However, core inflation has dropped below 4 per cent.

Consumption demand is trending down. As I've mentioned before, shrinking auto sales strongly suggests weak demand. Given the long value-chain of the auto industry, it will inevitably affect demand across a broad swathe of industries and also in the financial sector. Anecdotally, top level management institutes have had problems with placements, which is another sign of weak demand.

A combination of high prices in food, housing and clothing has hurt sentiment. There is no wealth effect since real estate prices have stagnated and domestic investors have lost money on the stock market. Plus, high interest rates mitigate against discretionary spending by borrowing against future incomes.

The RBI is now under pressure to cut rates to stimulate demand. Core inflation at below 4 per cent gives it the leeway to do so. However, overall WPI and CPI numbers make it likely that cuts will be minimal on March 19. It is also possible that the central bank will err on the side of prudence and not cut rates at all.

The RBI can take cold comfort from the fact that nothing it does will make much difference to food inflation. The causes of food inflation are multiple, but loose money sloshing out of the banking system isn't one. Reducing food prices will require luck in terms of good harvests, and a comprehensive overhaul of the current food procurement methods.

Perhaps policy-makers need to accept that food prices will continue to rise along with rural incomes, which are at least partly driven by MNREGA. Food inflation could, in fact, be a permanent feature for years. No government will roll back entitlements and there are too many vested interests involved for a serious overhaul of food procurement as well.

It's, therefore, difficult to see any economic segment roaring back in the near future. The global recovery is slow. This is one reason why crude prices have not exploded. Domestic investment levels have not risen and there won't be fresh investments until the government starts expediting blocked projects where huge sums are stuck in limbo.

The recovery is likely to see a very gradual acceleration of GDP growth. Earning visibility is not good, at least in the next two quarters and probably not in the entire 2013-14 fiscal. This would be fine if stock prices reflected the situation.

However, the market, or at least the major indices, continue to trade at above PE18 and the Nifty and Sensex are barely 1-2 per cent off their 52-week highs. The disconnect in trends when one compares the top 200 shares with mid-caps and small caps is startling. Share prices in the small-caps and midcaps space have seen deep corrections.

The overall market could correct downwards by a large amount in the next 6-12 months, especially if the FIIs reduce exposure. Political uncertainty, with elections due in 2014, guarantees some bearishness. The pressure on mid-caps and small caps will be greater due to the lack of FII interest in smaller scrips.

A 20-30 per cent correction could well be on the cards in 2013-14 while the upside may not be more than 10 per cent. Under those circumstances, it may be a reasonable bet to maintain allocations at current levels while earmarking larger amounts for future equity purchases.

Given a cycle of falling rates, fixed deposits or debt mutual funds with a timeframe of say, six months, may prove to be a pretty good bet. FD rates are likely to fall soon and debt mutual funds will also gain in a falling rate scenario. If the market corrects down below Nifty 5,200, it will start looking very attractive. Until then, medium term debt may be the best ticket.