A strong stockmarket performance is usually correlated with economic growth. It may also be driven to a large extent by low real interest rates. Neither factor has been in play in India in the last 12 months and yet, it's been a terrific year for equity investors.
The major indices are up by 20 per cent since January and the mid-cap and small cap performance has been even better. This seems crazy at first glance. The economy is reeling in the face of high inflation, low growth, record fiscal and current account deficits, political instability and policy inaction. While there are signs that the worst is over, nobody is predicting a big economic rebound.
Markets can behave irrationally for long periods. But the underlying reasons for the divorce between poor fundamentals and excellent share performance are clear in this case. The lion's share of investments in Indian equity in 2012 have come from overseas. FIIs have pumped in over Rs 85,000 crore in the last ten months.
For the FIIs, India is a reasonably attractive proposition. Europe is busted, Japan is busted, China is slowing down, the US has huge deficits, and the UK is just pulling out of recession. At the same time, First World inflation is low and interest rates are very low. There is excess liquidity in hard-currency regions and India offers relatively better prospects of capital gains. So it's a good "risk-on" situation for an FII.
The pattern of FII investments in big stocks has triggered churning by Indian investors. Domestic institutions have sold around Rs 15,000 crore in 2012 and retail investors have also sold. Some of the money, received from sales to FIIs, has been reinvested in smaller businesses, driving up midcaps and small caps.
The dollar and the euro liquidity has been one reason why the Indian market, and indeed most other markets around the world, have gained in 2012 despite low growth and major structural problems. Another possible reason is that shareprices discount expectations. If investors reckon things will improve, they will buy equity in anticipation of better times.
After three years of inaction, multiple corruption scandals and a total policy log-jam, the UPA has at last said it will do something to reverse the slide. It has actually done little of substance, beyond tinkering with gas cylinder subsidies and clearing FDI in retail. Many projects across sectors are still in limbo awaiting clearances or financial closure. Corporate expansion plans are on hold. And there's no sign that deficits will come under control. But even the faint hope that the government will do something has been enough to create a bullish mood.
There is a small window of opportunity for the UPA to do very much on the policy front. It faces a general election fairly soon. The government could fall in the Winter Session itself since it is dependent on external support. Nor is there consensus for reform amongst its allies.
Whatever pending legislation is passed in the Winter Session, well and good. It's unlikely that there will be any serious attempt to push through reforms after that. The Budget Session will be stormy and by then, the UPA's strategists will be looking to win votes in 2014, rather than to cut deficits. Projecting a little further, there's a fair chance the next Parliament will be hung. Hence, if policy changes don't occur in the next couple of months, they may not occur for several years, or at all.
Whether you decide to add serious equity exposure to your portfolio now depends on your broad assessment of three things. First, will the FIIs continue to find India an attractive destination? Second, how much will actually get done on the policy front? Third, where will rupee interest rates be six months to a year down the line?
My answers: 1) The FIIs may, or may not, be net buyers in 2013. Nobody knows, including the FIIs themselves 2) I don't think the government will get much done. 3) Interest rates will fall. If the FIIs stay, the market will remain buoyant. If they leave, share prices will fall. Lack of substantive policy action will hurt but you'd better be prepared to live with it.
The third point is the most important. If rates start falling, equity automatically becomes more attractive. If the FIIs leave and the market crashes, valuations become even better. There is a certain base rate of guaranteed growth and plenty of decent businesses in India. There is every chance that the interest rate cycle will trend down in 2013. On those grounds alone, be prepared to increase the equity weightage in your portfolio, especially if the market falls.