Year to date markets have rallied around 15 per cent on hopes of recovery and expectation of a reform-oriented stable government. The opinion and exit polls in India have been criticised for their record in predicting election results. But this time they got it right, at least the strong pro-Bharatiya Janata Party (BJP) sentiment. The market had been rooting for Narendra Modi as prime minister, who had fought the elections on a pro-development agenda and it got what it wanted. The BJP won a majority on its own, the first time after 30 years that a single party has won a majority. This stability will enable it to drive reforms.
Now that a pro-development government with a clear mandate has come to power, is all the good news discounted for the market? We believe markets will continue to go higher through the year and should give another about 11 per cent return by year end, with Sensex touching 27,000 levels. This would largely be driven by markets getting re-rated rather than an earnings recovery. We are likely at the bottom of the earnings cycle currently and expectations of a recovery, coupled with a stable government, will re-rate the markets to 16.5x on price-earnings (PE) basis from the current 14.5x, which happens to be the long-term average. We expect the economy and earnings to continue to be sluggish for FY15. However, markets will likely see through the sluggish macro data and possible poor monsoon.
Historically, too, in five of previous seven elections, markets gave a positive return six months and 12 months after general elections, with an average return of 11 per cent and 36 per cent, respectively. So far, markets have mimicked previous election time periods. Similar to 2009 elections, this time, too, markets have given handsome returns in the pre-election rally. Similarly, in terms of valuations, markets, just before the results in 2009, were close to the long-term average of 14.5x. In 2009, markets continued to trade at a premium to history in 16-18 PE band after elections. Given the positive sentiments around the new government, we believe something similar could happen this year as well.
While the recovery in the capital expenditure cycle will likely be a slow and gradual process, there are two other factors that could come to the aid of the current positive sentiments. These are: One, improvement in consumer and business sentiments. This could boost consumption. Two, removal of regulatory bottlenecks. The cabinet committee on investments has already started the process of easing regulatory bottlenecks. The new government will accelerate project clearances, in our view.
As far as markets are concerned, we think domestic plays will outperform exporters over the next 12 months as expectations of recovery and reforms take shape. Three key themes drive our sector preferences. One, high quality cyclicals. Two, reform plays and, three, beaten down deep cyclicals, which, despite the rally, are still below their previous peaks by a wide margin.
The author is managing director and head of research, Bank of America-Merrill Lynch
