Can the stock market rally be sustained?

While FII inflows have played a role in the current rally, it cannot be sustained unless there is a stable government which pushes economic reforms.

NILESH SHAH
Deputy MD, ICICI Prudential Asset Management

If FIIs come in looking for higher returns, this will help turn India Incs fortunes but a reform-oriented government is critical.

There have been many reasons for why Indias stock markets have performed so well. These include the global stock market rally; the Indian economys strength; buying by FIIs, mutual funds and others including retail investors; and short-covering. The million dollar question then, is whether the rally can be sustained.

Let me sketch out a scenario in which it can. Lets say the election results on the week-end surprise the market by giving a mandate to a coalition government which unleashes the kind of reforms the Narasimha Rao government did in the early 1990s.

Another possibility is the world, which is awash with liquidity, finds it more attractive to send funds to India as compared to the abysmally low returns being earned right now in mature markets. Capital starts flowing to India, and this makes the rupee start appreciating which, in turn, makes it even more attractive for foreigners who wish to invest in India. This improves liquidity in the financial system and helps keep interest rates low.

It also helps meet the large borrowing needs of the government as well as of corporate and retail borrowers. Credit-starved companies who then become more liquid are able to put assets into productive use, pushing both economic growth and corporate profits to a higher trajectory. GDP growth gets a boost, and corporate valuations also begin to look better since their earnings will rise.

A reform-oriented government which is able to attract capital flows will be critical for pushing the equity markets to a substantially higher level compared to what we can imagine right now. This time the task of attracting capital lies with the government as major industrial houses have their plates full just dealing with the challenging economic environment.

Can this happen? Of course it can. Many of the last lot of state elections were won on the development plank. When those who focussed on bijli, sadak and paani won the elections, there is an incentive for the next government to focus on augmenting our savings and increasing capital flows the economy and the capital markets will get taken care of automatically.

Obviously, real life is not as simple. Global uncertainties, the outlook on the monsoon and on oil prices will continue to affect the economy as well as the stock markets. But these will be, at worst, speed-breakers. They cannot change the direction of either the economy or the stock markets, except for a very short period.

The high fiscal deficit and the large borrowing programme also means there is a limited window which has to be seized by the next government. A loose monetary policy could trigger off inflationary pressures next year, and combined with the governments borrowing, this could crowd out private borrowers this is something the next government will have to watch out for, and tackle despite all the compulsions of coalition politics.

The future of the economy lies in the hands of the new government which can either take the economy to a higher growth path (and the stock market will follow) or it can waste the opportunity and fail to capitalise on Indias potential to perform like China.

VIBHAV KAPOOR
Group CIO, IL&FS

Certainly things look a lot rosier today, but the global economy is still in trouble in India, the fiscal deficit remains a real issue.

Over the past nine weeks, both the global as well as Indian markets have had a dream run with most indices gaining a whopping 40-50 per cent from their lows in the first week of March 2009. The rally has been predicated on the presumption that the global economy has bottomed out and the worst of the global recession is over.

Economic data coming in from countries like the US, China and India has been a lot less depressing than envisaged. The various stimulus packages by the government and the liquidity injected into the system have also played a role in the markets performance. In the case of India, corporate results have also been slightly better than expected.

The optimists believe that we are back in a major bull market and that Indian equity markets will continue their assent uninterruptedly from here onwards. They believe that the global economy has bottomed out; and India is in a position to decouple from global trends in terms of its economic performance.

While the outlook may appear brighter that it was a few weeks ago, it is too early to say everything is going to be hunky dory. A substantial part of what looks like an improvement appears so because production levels in October-December were exceptionally bad. The re-stocking of inventories as well as the immediate impact of the fiscal stimuli were, in any case, expected to lead to this kind of a bounce.

On the other hand, there is no doubt that the imbalances in the global economy are here to stay for quite some time. The markets have been delighted with the thumbs-up given to the US banks by the so-called stress tests. Several economists and analysts have however, questioned the integrity of these tests and their usefulness in assessing the health of the US financial system.

As far as India is concerned, while there may be some sort of decoupling from the global economy/markets, it cannot be anybodys case that in the event of a renewed downtrend, the Indian markets will escape unscathed. Moreover, significant danger lurks round the corner from the very steps which have led to this apparent recovery.

The huge fiscal deficits as well as huge injection of money have greatly increased the risk of higher inflation and a hike in the interest rates in the future. Given this, it is difficult to predict how far the government will be able to provide further fiscal stimuli or even ease monetary policy. While corporate results appear reasonably good, a large part can be ascribed to the extremely depressed expectations of analysts.

Other factors which have helped include the depressed conditions in the last quarter, the fiscal stimuli, easing monetary conditions and, perhaps, even the election-spending. In sectors like the automobiles and cement, the higher profits are a direct result of the substantial decline in excise duties. Once the fiscal stimuli are withdrawn, corporate profitability may get negatively impacted.

The markets appear to have discounted most of the imminent good news. Current valuations reflect an upgrade of profit expectations during 2009-10. At a Nifty level of 3,800-3,900, the earnings per share in 2009-10 will be discounted by over 13 times (even after assuming profitability growth of 8-10 per cent).

In conclusion, there is a good chance that the worst of the bear market is behind us; but it is too early to take a call on the resumption of an uninterrupted bull market.  In our opinion therefore, the best-case scenario for the next few months is for a range-bound Nifty trading at levels between 3,000-3,900.