Market Outlook: Local push, global pull

The Indian economy has returned to normalcy with a smart recovery in industrial production, credit offtake and exports, hinting towards a broad-based revival in the real economy. In addition, the fiscal position is expected to improve considerably on the back of the third generation (3G)/broadband auction bonanza and the slew of initiatives taken to curtail food and oil subsidy burdens.

Notwithstanding the low base effect, the improving macro environment has translated into a strong rebound in the earnings, as borne out by the Q4 earnings season. The earnings of the Sensex companies registered a growth of 27.6% year on year (yoy) vs about a 15% growth in the previous quarter. Importantly, the strong earnings growth momentum is likely to continue in the years ahead with the FY2011 earnings expected to grow by 21% yoy (though commodities remain the key risk given the recent softening of base metal prices).

Further, the earnings growth momentum in FY2012 and beyond would be supported by three key pillars:

(1) A surge in infrastructure creation across sectors;

(2) booming domestic consumption;

(3) ground-breaking tax reforms. Effectively, the current fiscal would mark the beginning of the next earnings growth cycle.

The key risks to our thesis are:

(1) Scarcity of foreign inflows that are essential to support a high real gross domestic product (GDP) growth and fill in the fiscal gap;

(2) the continued weak domestic flows in domestic institutions, mutual funds and insurance companies;

(3) the inflationary pressures resulting from the hike in fuel prices and a possible abnormal monsoon this year as well.

While the domestic indicators have reported reassuring trends, the developed economies have weakened once again. While the European crisis was already putting a question mark on the sustainability of the global recovery, the recent economic data from the USA has turned weak and revived debates of a double-dip recession. The weakness primarily stems from the worsening trends in the housing space after the expiry of tax benefits that has also dampened consumer sentiments.

All in all, the short-term outlook remains muddied by the troubles in the developed nations with persistent doubts over the recovery in the USA and the unresolved challenges for the East European nations. Hence, the valuation for the Sensex is likely to hover around the long-term average multiple of 15x (one-year forward earnings). Having said that, the medium-to-long-term outlook remains strong driven by India’s robust macro fundamentals and the beginning of the next earnings growth cycle.

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