Over three-four months, significant hopes have been building up that the reformist measures initiated by the finance minister has taken the economy to an inflexion point. The markets' hopes have also been buoyed by an emerging downtrend in the inflation trajectory (albeit only reflected in the wholesale price index). Also, the global economy, particularly US and China, has lately shown some signs of improvement.
Rating agencies have clearly been pressuring the government for policy action. The finance minister's focus on reduction in fiscal deficit is targeted towards this end.
However, keeping in view the need to accelerate economic growth, the Budget would need to draw a fine balance between growth and limiting the fiscal deficit. There is, unfortunately, not much scope to reduce non-development expenditure or to increase taxes. The burden will therefore, fall on development expenditure, which will need to be cut by at least Rs 100,000 crore. This will have an adverse impact of at least 0.25 per cent on the growth in gross domestic product for (GDP) FY14. To counter this, the Reserve Bank of India would need to follow a more accommodative monetary policy. While this looks feasible, higher oil and commodity prices pose a risk to this scenario.
The other area of concern is the current account deficit (CAD), expected to cross five per cent of GDP in FY13. Consequently, a risk of further rupee depreciation is significant, which could then adversely impact inflation. Unfortunately, India is largely dependent on foreign flows of capital. Any short-term risk aversion in the global investing community could reduce or stop this flow of capital.
While the government has taken the right steps in trying to change the sentiment, capital investment, both in infrastructure and in the private sector, is still to take off. On the other hand, the persistently high inflationary pressures are perhaps beginning to have an adverse impact on consumption. Thus, all components of GDP - consumption, investment, government expenditure and CAD - are under pressure. As a result, recovery may not be as V-shaped as expected by many analysts.
The stock market has been building in a reasonably optimistic scenario in relation to both a higher rate of GDP growth and a significant loosening of monetary policy. While the latter is likely to fructify to some extent, the former seems less likely. Thus, earnings estimates carry a downside risk. A rerating of multiples also appears unlikely in view of the impending elections. The markets have begun to underperform in the past few weeks, partly due to the huge outperformance of 2012 as well as disappointing corporate numbers. More, a degree of uncertainty on the trajectory of economic growth appears to be coming to the forefront. As usual, great hopes are pinned on the coming Budget. Given the finance minister's record and his recent statements, it is not likely to disappoint the markets. However, there is only so much a budget can do. With expectations already high, it might be difficult for him to positively surprise.
Given the above circumstances, the markets are likely to trend downwards over the few weeks. A moderate to reasonable fall in the Nifty cannot be ruled out.
The author is group chief investment officer, IL&FS Limited