The Indian equity market performed surprisingly well over the past year, given the slowdown in the economy to a decade-low growth rate, without a commensurate fall in inflation. That performance of the market, against the backdrop of downgrades and slippages, defies logic; if the logic is the market can only perform in an environment of robust growth and earnings upgrades. Last year's rally, however, follows a different route; all risky assets got re-priced upwards, accompanied by a fall in risk spreads, due to direct intervention of Western central banks in certain segments of credit markets. Our market also was a beneficiary of capital flows into risky assets across the globe - in fact, CY12 FII inflows into the Indian market, at approximately $24 billion, were the second highest ever.
If the market rallied due to capital flows despite economic weakness, the situation begs an important question – is another year of solid returns possible, even if the Indian economy remains lacklustre? It seems unlikely, as most measures of risk, barring bond yields of a few European countries, are down close to pre-crisis levels. So, that leaves us with only one possibility of eking out positive returns this year; a reversal from nearly three years of slowdown, downgrades and anaemic corporate earnings growth in our economy.
The now rising expectations of revival in domestic growth have been supported by both policy actions and a near-consensus that the central bank would cut rates, the first of many to come, in the next policy meeting. The nature of slowdown though, suggests that we are supply-deficient rather than demand-deficient – how else does one explain the surge in current account deficit even as our currency weakens sharply. Thus, a rise in investment spending is more important than general recovery in aggregate demand. But investment spending has slowed down for more than just interest-rate related reasons. Change in environmental norms in mining, non-indexation of household rates to input costs in the power sector and some real negative surprises, such as fall in domestic gas production, have all contributed to the slowdown.
The steps taken to address the issues, such as the Mining Bill, Land Acquisition Bill and formation of the high-powered Cabinet Committee on Investment, are all welcome moves. Likewise decisions to limit fuel subsidies, allowing foreign direct investment in multi-brand retailing and paving the way for new bank licences are all sentiment boosters. However, speedy implementation of projects in pipeline, with necessary policy changes to make those viable, is the need of the hour. If the equity market has to sustain the momentum this year, we cannot afford to see any more downgrades to estimates. In the short-term, while the debate on effectiveness of policy steps and therefore, likelihood of recovery will continue, the market itself is unlikely to see any significant upmove in the short term, given the extent of primary issuances by both the government as well as the private sector.
Overall, the outlook is one of sedate short term, with the second half confirming a growth revival, or otherwise. Amid all this, one should not lose sight of the fact that equities have been the worst performing asset class over the last five years, and reversion to the long-term trend will eventually happen. For a long-term investor, now is as good a time as any to invest in the market.