Morgan Stanley sees risks rising

'Equities 20% above fair value'

Morgan Stanley has said it would be "cautious" on the Indian equity market in 2005, noting that the "market is about 20% above fair value, and the risks are rising."

In a note to clients Thursday, the investment bank said, "the market looks vulnerable on fundamentals (macro, earnings, and valuations) but is supported by strong liquidity driven by a weakening U.S. dollar."

Morgan Stanley said the strength of the rupee versus the U.S. dollar will determine the inflow in the market. An associated factor is the rate of inflation given its potential dampening impact on growth, the note said.

The trend in corporate margins in the January earnings season would be another key factor.

"Earnings may peak out in the quarter ended December and we think that margins could come under pressure with the widening gap between consumer and producer price inflation."

The pace of capital expenditure implementation would be another deciding factor.

"No doubt capex announcements are happening at a frantic pace but the key is how much gets implemented."

Morgan Stanley said the country's overall capacity utilisation rate seems to be running quite high, especially in infrastructure, and hence a recovery in capital expenditure is essential for sustaining medium growth.

Also, the extent of tax reforms the government undertakes in the February budget will be important for the revenue deficit and hence supply of domestic capital.

"While stock market returns could remain strong until the budget, we think India's relative returns could start coming under pressure from the second quarter of 2005."

The investment bank was overweight on Sun Pharmaceuticals, Hindustan Lever, and ITC.

Morgan was underweight on shares of interest rate sensitive companies and domestic sectors such as the State Bank of India and the automobile sector.

Morgan also said upstream energy companies like Oil and Natural Gas Corporation look "good" on valuations whereas capital goods companies may benefit from a cyclical recovery in capital spending in 2005. But companies like Tata Steel could be vulnerable owing to a weakening US dollar.