India's finance minister has pledged to keep the deficit close to 5.3 per cent in the current financial year. This target is at risk, given slower-than-expected revenue collection, low divestment proceeds and tepid response to the telecommunications bandwidth auction.
However, the recent direction of fiscal policy action has revived hopes that domestic growth rates will improve. Fuel prices have been raised, there has been an increased willingness to cut fiscal deficit, initiate cuts in government spending, restructure state electricity boards and liberalise some foreign investment limits. These serve to ease investor concerns, stabilise markets and help economic growth. To return the economy to a higher trajectory of growth will require further, harsher and far more politically contentious reforms. These include land and mineral resource allocation, further moves to improve the investment climate and more cuts in fiscal and current account deficits. By building a consensus in Parliament, we expect the government to be able to push through the goods and services tax, a new direct taxes code, land purchase and financial sector reforms. These will change the game and help return yearly gross domestic product (GDP) growth to over eight per cent.
Indian equities are expected to rise if domestic political concerns continue to ebb and the situation in Greece clears. The quantity will depend on the government approving disinvestment of more public sector undertakings and further financial services sector reform. Indian equities are trading at a historically cheap 12.6x versus their average of 13.8x (one-year forward earnings basis - 10-year average). Earnings are expected to grow 15 per cent yearly during FY12-14. This level looks attractive for investors looking to invest in the Indian market over the next few years. Although the current earnings season's momentum has been slack, we expect further fiscal policy action, improved investor sentiment and easier monetary policy will drive earnings from the first quarter (Q1) onwards. Flows from foreign institutional investors are likely to continue. We therefore, maintain our overweight stance on equities.
In the medium term, we expect Indian equities to continue to outperform against regional peers. Our Nifty target is 6,200 for March 2013. The main risks to our forecast lie in any reversal of domestic policy momentum, political uncertainty and a significant slowing of the US recovery. Our preferred sectors are consumer staples, health care and information technology. We are not as optimistic on telecommunications, utilities and industrials.
On the fixed income side, bond yields are expected to come off, given the monetary easing and improvement in liquidity seen from the fourth quarter. We also expect a 50 basis points (bps) rate cut in that quarter and a further 25 bps cut in next year's June quarter. The short end will be driven by liquidity and long-end yields by policy action and government borrowing in the second half. Returns of liquid funds should start coming off, with lower rates at the very short end. Accrual funds still have some upside and it is a good time to lock in these funds. Medium- term funds look attractive, as they offer high accruals and have the ability to generate capital gains, along with softening yields. We suggest investors consider long duration funds or bonds as a portion of allocation opportunistically.