The near-term outlook for the capital markets has turned distinctly positive. The turnaround in sentiment was triggered by the pleasant surprise in the form of bold reforms, such as substantial hike in diesel prices and allowance of foreign direct investment (FDI) in certain sectors. Sceptics can argue that cut in diesel prices may not be adequate to contain the fiscal deficit nor FDI policy will fetch foreign capital in the near future.
Therefore, impact on macro numbers showing fundamental story may take a while, say two to three quarters. One should not forget that many-a-time sentiment drives fundamentals. For instance, if enterprises are optimistic about the future they take up new investment, which in turn raises output, drives employment and has a cascading impact on the economy.
Stock markets will always run ahead of fundamentals based on expectations, indications and directions of policy. Now that the government has got tremendous positive response based on the first spate of reforms and has discovered that coalition partners do not have the courage to pull the rug from under their feet, it will be emboldened to table more reforms in Parliament, which can include hiking FDI limit in insurance, pension sector reforms and clearing the land acquisition bill for industrial and development usages, among others.
If Reserve Bank of India (RBI) supports the fiscal reforms with a rate cut and/or cash reserve ratio (CRR) cut, sentiment will get a further boost. More importantly, a rate cut will help to contain the slowdown in growth. With a rate cut now, one can expect banks to reduce their lending rates as well. That eases the interest burden on leveraged companies and also creates a more conducive environment for companies to take up new and expansion projects.
Another factor that is positive for the near-term market outlook is that the earnings season for the July-September quarter has got off to a good start. While a few companies may have disappointed, more have positively surprised or met expectations. So, it is reasonable to assume 12 per cent earnings growth in FY13 and 14 per cent growth in FY14. With these assumptions, Nifty currently trades at a valuation of 13.5 times FY14 earnings. This valuation is fair and leaves reasonable room for appreciation. The current market valuation is near the long-term average and way below the peak valuations of the bull markets. However, we live in a turbulent world, which is not free of risks and uncertainties. The key global events to watch out for are the US presidential elections and continuing problems in the Euro zone. Back home, one has to be cautious about further slippages in fiscal and current account deficits and RBI's reluctance to cut rates if inflation remains high. Also, the political situation continues to remain fragile.
In this environment, for equity exposure, I would think one should still play defensive and prefer pharmaceutical, FMCG and IT sectors, which are relatively resilient to global issues as well as domestic political uncertainties. Besides, the cement sector, in particular mid-cap cement stocks catering to northern or eastern regions, should do well. There is not much new cement capacity in the pipeline for the next two to three years, and these companies should see good times. Also, one can add some bank stocks as valuations are attractive and these are proxy for the economy and core sectors.
The author is chairman, IIFL