With a four-month equity rally showing signs of fatigue, the focus is on Budget 2013 to provide further impetus.

Historically, budgets around election years have been anything but fiscally prudent. The situation may be different this time around with a huge fiscal deficit and an unsustainable current account deficit leaving virtually no room for any form of fiscal largesse.

Though portfolio flows from overseas have been robust so far — 1.3 trillion rupees in 2012 and 222 billion rupees in January 2013 — overseas investors will be demanding continued fiscal consolidation and structural reforms going ahead. Even the RBI, in its latest monetary policy statement, said future interest rate cuts shall depend on fiscal consolidation and structural supply-side reforms.

The finance minister faces the uphill task of balancing fiscal consolidation and structural reforms with populist measures designed to boost the chances of the UPA government coming back for another term. However, considering developments over the last four months, it seems the government is ready to bite the bullet and bring about economically prudent policy initiatives, even if they come at a cost.

Reforms such as FDI in multi-brand retail, a cap on domestic LPG cylinders, an increase in fuel prices and railway fares — all point to the government’s resolve. Whether this continues in an election year or fizzles out under political compulsions is something that will be keenly watched.

Some of the key points one needs to look at in the budget are fiscal deficit projection, government borrowing plan and subsidy estimates for 2013/14. The five-year fiscal roadmap unveiled by the finance minister in October had put the 2013/14 fiscal deficit target at 4.8 percent of GDP, which may be an uphill task in an election year.

But the fact that the fiscal deficit for 2012/13 is unlikely to exceed the revised target of 5.3 percent of GDP — despite forecasts to the contrary — makes it achievable, provided enough political will is mustered. A net borrowing plan of 5 trillion rupees or less for 2013/14 should comfort the bond markets.

On the taxation front, despite the fiscal burden, the government will be wary of increasing taxes on individual taxpayers and businesses, as it needs to increase domestic savings and jump-start investments.

There have been rumours of an inheritance tax as well as higher taxes for the super-rich (similar to the U.S.) coming in the budget, which if they do come, can be damaging. We cannot afford to have the rich shift base out of the country and/or another round of black money creation. There is empirical evidence to show that lowering tax rates and widening the base has led to higher growth in tax collections.

The government is also likely to introduce the revised Direct Tax Code (DTC) Bill in this Budget, and give a road map for introduction of the Goods & Services Tax (GST). Investors and taxpayers shall be anxious to know key provisions in the DTC Bill, particularly those related to investment-based income tax exemptions and their impact on tax liabilities.

Pressures from the widening current account deficit and investor apathy towards financial assets may force higher income tax benefits for financial savings instruments in order to make them attractive. We may expect the budget to widen the scope of the Rajiv Gandhi Equity Savings Scheme (RGESS) and give separate exemptions (over and above the existing limit of 100,000 rupees under Section 80C) for the New Pension Scheme (NPS) and pension plans from insurance companies. This should be rewarding for small savers and investors.

The Indian economy and financial markets are at a critical juncture after four months of policy action that have raised hopes of a brighter economic future and better investment returns. We will be keeping our fingers crossed.

The rally in the Indian stock markets, fuelled by the so-called reform announcements, seems to have fizzled out. Frontline indexes have retraced more than 60 percent of the gains made since Sep. 13, 2012, the day the reform measures were made public.

Stock market sentiment turned bullish after the reforms were announced, which typically followed Europe’s unlimited bond-buying plan revealed a week earlier and coincided with the launch of QE3 in the United States.

However, subsequent developments such as the Reserve Bank of India’s (RBI) refusal to cut the repo rate citing persistently high inflation at its October policy review, slowing growth and worsening trade and fiscal deficits, have dented some of that exuberance.

Fiscal concerns seem to have staged a comeback. The 2G spectrum auctions fetched not even a fourth of the targeted amount (400 billion rupees) and the disinvestment process is yet to take off. The fiscal deficit for 2012-13 runs the risk of exceeding even the revised target of 5.3 percent of GDP. Also, despite a weaker rupee and slowing domestic growth, the trade deficit continued to expand, clocking a high of $21 billion in October. As a result, the rupee has slipped back to 55 plus levels.

Concerns over the “fiscal cliff” in the United States and renewed concerns on Greece have given rise to risk-off trade overseas, thereby affecting liquidity flows in India.

If we weed out the reform announcements for a moment, then the movement of the Indian stock markets from September onwards can be attributed to two factors — the initial upside due to risk-on trade following QEs in Europe and the United States, and later the downside due to risk-off trade after concerns on the U.S. “fiscal cliff” and Greece.

The approaching “fiscal cliff” is a game of brinkmanship in which both parties will ultimately yield, but not before extracting their pound of flesh. This may lead to some anxiety in global investment markets, but the probability of this escalating into a full-blown crisis is low.

Fundamentally, corporate earnings growth seems to have bottomed out in the July-Sept 2012 quarter. Going ahead, earnings downgrades should give way to earnings upgrades. But recovery is likely to be slow. Present valuations, though not screamingly cheap, are not expensive either. At close to 14 times one-year forward EPS, the BSE Sensex is trading in the fair value range.

The most important factor, however, is global commodity prices. They seem to have ended the 15-year bull cycle and are headed for a deep correction. Lower commodity prices can be a boon for India, which imports almost 70-80 percent of its commodity requirements.

Add to that the subtle rate cut hints from the RBI in the Jan-March 2013 quarter and we may be headed for a much-needed reprieve. Technically, the markets seem to have completed a healthy correction to the previous rally and are at crucial support levels. Pessimism and disbelief seem to be rampant among investors as they have used this rally to book profits. The markets have a habit of doing exactly the opposite of what the masses want them to do.

The ongoing winter session in parliament is crucial as a number of important bills will come up for approval. Bills related to FDI in insurance and pension, Companies Bill (Amendment) and Land Acquisition Bill are some of the important ones that need to be passed for the recent upswing in sentiment to continue.

The opposition has plans to push for a vote on FDI in retail, whereas the government is trying its best not to let it happen. A lot will depend on how many reform bills are passed in this session. Will it be another wasted opportunity? Or will it finally herald the beginning of a new era? The near-term future of stock markets depends on that. We are keeping our fingers crossed.

Indian stock markets have hardly gone anywhere since June, with the Nifty hovering in the 8-9 pct range. But the coming months may see a breakout of this range as volatility, as measured by the India VIX index, seems to be rebounding from four-year lows, after having fallen for three months in a row. A short-term break, out of the range, on the downside seems more probable.

Having said that, the recent collapse in stock prices of some companies, in which promoters had pledged a significant portion of their stakes, shows that the system is cutting down on leverage at the very grassroot level — the stock broker. When this happens, you know that ‘the bottom is nigh’.

The near-term outlook for Indian markets, however, also hinges on developments in the U.S. and Europe. U.S. equities seem to be at the height of their infatuation with QE3 and may be in for a rude jolt.

The recent leg of the rally in U.S. equities that started in June seems to be tiring out while Europe behaves like someone who promises a lot but yields nothing. As far as quantitative easing is concerned, the law of diminishing marginal returns has kicked in. Financial markets have turned less responsive every time the bond-buying bazooka is pulled out.

On the domestic front, the probability of mid-term polls is low simply due to the lack of a strong alternative, despite occasional rumblings by some regional parties claiming to build a ‘Third Front’. If at all a Third Front materialises and gains power, we know what to expect, going by our experience of the 1990s.

A sovereign rating downgrade remains a credible threat due to India’s dependence on foreign capital flows in the wake of a persistent current account deficit. India’s rating at BBB- is already at the lowest ‘investment grade’ level and a step away from being accorded junk status. S&P had cut India’s outlook to negative from stable in early April.

After the weak GDP numbers for the second quarter of this fiscal, released on August 31, S&P has reiterated its downgrade threat if the government fails to correct the fiscal situation. Presently, India, rated at BBB- by S&P, has been clubbed with countries like Azerbaijan, Croatia, Iceland, Latvia, Morocco and Uruguay, none of which come near it on grounds such as sheer economic size, growth potential, stability and diversity.

It is ironical that countries such as Ireland, Italy and Spain enjoy a better credit rating than India, despite being in a recession, having stressed sovereign balance sheets and being in the eye of the European sovereign debt crisis storm. Even countries like Bulgaria, Colombia, the Bahamas, Kazakhstan, Lithuania, Peru and Thailand have a better rating than India, a fact which hints at the fallacies of rating methodology.

Jim Rogers recently mentioned that he is underweight on India because of the high debt to GDP ratio, which according to him, has reached 90 pct. What does he have to say about Japan and Europe? Again ironically, he seems to be bullish on Japan.

Despite all ironies and the fallacies in the rating process, we must accept that we need to maintain our rating at the investment grade (BBB) level, simply because we need those foreign capital flows desperately. Almost all long-term foreign investors have a mandate to invest only in economies rated investment grade and above. A fall below BBB may stop them from investing in India. Indian policymakers know this, despite having rejected downgrade reports recently. No wonder the market is rife with rumours of an impending fuel price hike after the monsoon session of parliament.

At its mid-quarter monetary policy review on June 18, the Reserve Bank of India (RBI) kept its rates unchanged despite expectations of a cut. To further augment liquidity and encourage banks to increase credit flow to the export sector, the RBI has increased the limit of export credit refinance from 15 percent of outstanding export credit of banks to 50 percent, which will potentially release additional liquidity of over 300 billion rupees, equivalent to about 50 basis points reduction in the CRR.

This is an excellent move as lower rates together with a weak rupee should benefit exporters. The overall policy announcement disappointed the markets with stocks down sharply and 10 year g-sec yields up more than 10 bps post policy.

The Reserve Bank had front-loaded the policy rate reduction in April with a cut of 50 basis points. This decision was based on the premise that the process of fiscal consolidation critical for inflation management would get under way, along with other supply-side initiatives. The assessment of the current growth-inflation dynamic is that there are several factors responsible for the slowdown in activity, particularly in investment, with the role of interest rates being relatively small. Consequently, further reduction in the policy interest rate at this juncture, rather than supporting growth, could exacerbate inflationary pressures.

Despite the rate cut in April and clear positioning by the RBI, the government has failed to bring about much needed reforms and address supply bottlenecks. In fact, the impending diesel price hike has been postponed once again due to political pressures.

Even as the manufacturing Purchasing Managers’ Index (PMI) for May suggested that industrial activity remains in an expansionary mode, there is no question that the pace of expansion has slowed significantly. In this context, it is relevant to assess as to what extent high interest rates are affecting economic growth. Estimates suggest that real effective bank lending interest rates, though positive, remain comparatively lower than the levels seen during the high growth phase of 2003-08. This suggests that factors other than interest rates are contributing more significantly to the growth slowdown.

In the wake of increasing allegations that hawkish monetary policy dented growth, the RBI has sought to clarify matters. Indeed, more than interest rates, it’s the policy uncertainty and lack of action by the government that has led to growth slowdown.

The recent fall in the rupee has increased the competitiveness of Indian exports and should act as demand stimulus. High interest rates have taken away a large part of this currency-induced gain in competitiveness; this is evident from the fact that despite a weaker rupee and a stronger yuan, Chinese exports have risen in April-May 2012 whereas Indian exports have fallen by about 4-5 percent on a year-on-year basis.

Notably, the widening wedge between deposit growth and credit growth is intensifying liquidity pressures. However, open market operations (OMOs) have substantially eased liquidity conditions. The Reserve Bank will continue to use OMOs as and when warranted to contain liquidity pressures. Probably the RBI wants to preserve the already reduced CRR weapon for harsher times. The evolving growth-inflation dynamic will continue to influence the Reserve Bank’s stance on interest rates.

The widening current account deficit, despite the slowdown in growth, is symptomatic of demand-supply imbalances and a pointer to the urgent need to resolve supply bottlenecks. The failure to pass on high oil prices had resulted in demand for oil remaining uncharacteristically strong despite slowing growth, resulting in higher trade and hence current a/c deficit.

The RBI has this uncanny ability to surprise markets. In April, it surprised the markets with a larger-than-expected rate cut. This time it has done so with no cut at all. It has rightly blamed the slowdown in growth to factors other than high interest rates. Whereas a rate cut today would have been positive for markets, by not succumbing to popular demand, the RBI has put the onus of rejuvenating growth on the government. After close scrutiny, a number of reasons can be put forth for RBI action (or lack of it) — high inflation, inability to formulate a credible fiscal consolidation process (procrastination on diesel price hikes is an example) and expectations/fears of further quantitative easing in developed markets. Since concerns from overseas (read Europe) refuse to go away, it seems that the RBI is preserving its ammunition for a day when it would be needed the most.

We seem to be moving towards stagflation, with growth at 5.3 percent and inflation (WPI) at more than 7 percent. In fact, CPI inflation for May came in at 10.36 percent, justifying the RBI’s latest stance. Even if the RBI had cut rates, there is doubt as to what extent banks would have followed it.

Expectations of money printing abroad may have given the RBI some room to continue its crusade against inflation and resist pressure to cut rates immediately to ease liquidity. Also, as rightly mentioned by it, there is a risk of commodity prices rising and thus adding to inflationary pressures, if developed markets start printing money once again. The point is, how long would it wait for Quantitative Easing (QE) abroad, before finally succumbing to the pressure and cut rates? A game of brinksmanship seems to be going on in between the RBI and the government. Let’s see who blinks first.

The last time the Reserve Bank of India (RBI) surprised the markets was when it announced a 75 bps cut in cash reserve ration (CRR) days before its mid-quarter review of monetary policy on March 15. It did so again in its annual monetary policy meeting on April 17, with a 50 bps repo rate cut when the markets were either expecting no rate cut or a 25 bps rate cut at best.

Why did the RBI cut the repo rate by 50 bps, amid growth showing signs of a recovery and the general belief that the worst in industrial growth was already behind us; when food inflation had started rising and with all the suppressed inflation in retail fuel, coal, power and fertiliser prices?

Did it give in to moral persuasion from the government and the industry? Or was it because cutting rates later in the year would have been difficult, if not impossible? As if to mock the rate cut, consumer price inflation for March came in at 9.5 pct the very next day.

As per media reports on April 19, the Commission for Agricultural Costs and Prices (CACP) recommended a hike of 15-40 pct in the minimum support price (MSP) of various kharif crops during FY13. Though these are just recommendations, historically, the actual hike in MSP has almost matched the recommendations. This is again likely to add to food inflation. With the current account deficit likely at 4 pct of GDP in FY12 putting further pressure on domestic currency and the consequent need for overseas inflows to finance the same, a rate cut was the last thing that should have been done.

Also, the uncertainty relating to monsoons, spike in food inflation after the transitional decline in Dec and Jan 2012 and the impending retail fuel price hikes, all create doubts over the continuance of the trend in the foreseeable future.

The RBI Governor said “the reduction in the repo rate is based on an assessment of growth having slowed below its post-crisis trend rate which, in turn, is contributing to a moderation in core inflation. However, it must be emphasised that the deviation of growth from its trend is modest. At the same time, upside risks to inflation persist. These considerations inherently limit the space for further reduction in policy rates.”

“Moreover, if subsidies are not contained as indicated in the Union Budget last month, demand pressures will persist, and will further reduce whatever space there is for monetary easing,” he said.

“Overall, from the perspective of vulnerabilities emerging from the fiscal and current account deficits, it is imperative for macroeconomic stability that administered prices of petroleum products are increased to reflect their true costs of production.”

The muted response of the markets is thus understandable in light of the above, as they doubt the sustainability of the change in policy stance. Going ahead, among other factors, further rate cuts will depend on the trends in food and core inflation, global oil prices, hike in retail fuel prices, monsoon and government action on the subsidies front. Hence, it is doubtful that we would see further cuts in the coming months, unless something really gives way.

Debt investors would thus do well not to get carried away by the rate cut and start building duration. The risk reward and outlook continues to remain in favour of the shorter end of the curve as liquidity is likely to ease further, cooling the money market and short-term rates.

Nevertheless, the 50 bps repo rate cut will have some impact on the yield curve and debt and equity markets. In bond markets, the effect of the rate cut coupled with easing liquidity, shall be more pronounced at the shorter end of the curve as supply concerns limit the impact on long-term yields. In fact, benchmark 10 year g-sec yields, three days after the rate cut, are higher than where they were immediately before the rate cut. The yield curve is likely to steepen going ahead and hence opportunity for investors lies at the shorter end of the curve and not at the longer end.

The rate cut brings in some good news for stock markets too. The 25 bps cut in base rates announced by most banks following the repo rate cut should ease the general cost of capital, albeit marginally, and probably puts a floor in place for equity markets.

On the bonds side, the status quo remains unchanged as short- term debt funds or ‘high yield accrual funds’ continue to enjoy a favourable outlook as compared to their longer term peers. Those investors fond of taking a higher risk and willing to try the longer end of the curve may do so through dynamic bond funds which have the ability to sift through maturity and actively manage duration, thereby protecting downsides pursuant to sharp up-moves in interest rates.

Like every budget since the subprime crisis of 2008, the one on March 16 will see the Finance Minister walking a tightrope between fiscal consolidation and growth. The only difference being — this time the government is really constrained to provide a fiscal boost to consumption.

Hence, support to growth can most likely be in the form of a boost to investment by adopting critical reforms and creating an atmosphere conducive enough for private investment to come back. With the markets and the Reserve Bank of India (RBI) breathing down its neck looking for a credible plan on bringing fiscal deficit down in the medium term and concrete steps to encourage private investment, the task is cut out for the government. It is now more a question of political will than anything else.

The results from state elections in Uttar Pradesh, Punjab, Uttarakhand, Manipur and Goa are likely to test the political will and commitment of the government to reforms and fiscal prudence.

Real GDP growth has dipped to 6.1 pct in Q3FY12, the lowest since Q3FY09 — the peak of the subprime crisis. A combination of high inflation, increased cost of capital and the weak global economy resulted in the slowdown in growth. Inflation has shown signs of moderation over the last couple of months, though doubts remain as to its sustainability. Cost of capital has continued to remain high in the wake of tight liquidity, high fiscal deficit and absence of clear direction from the RBI on interest rates.

India Inc will be looking towards the Budget to provide a credible plan on bringing down fiscal deficit and government borrowing to bring interest rates down. Also, investment as a percentage of GDP has moderated from about 33-34 pct to 30 pct levels over the last four years, thereby bringing the sustainable (non-inflationary) rate of growth of the Indian economy to about 7 pct. India Inc expects the government to kick-start reforms to boost private investment in the upcoming budget to bring the sustainable growth rate higher.

Mere lip service may not be enough in this budget. Markets need a concrete plan for execution. If fiscal deficit is projected lower, the assumptions and expectations forming the basis for such projections should be realistic and not over-optimistic. The Budget presented in 2011 had projected fiscal deficit at 4.6 pct of GDP, based on some practically weak assumptions such as a 9 pct GDP growth rate and understated subsidy bills. The reality is that fiscal deficit for FY12 is likely to exceed the budget estimate by a full percentage point.

The common man’s wish list, as always, includes a tax bonanza for the individual taxpayer by way of an increase in the maximum exemption limit (presently at 1.8 lakh rupees p.a.), widening of tax slabs and increase in various deduction limits prescribed under sections 80C, 80CCF (investment in infrastructure bonds), 80D (mediclaim premium), 24(b) (interest paid on home loans). The proposed Direct Taxes Code has sought to remove ELSS schemes by mutual funds and ULIPs and other insurance plans by insurance companies from the ambit of Section 80C. The common man would want this reversed as ELSS schemes present the best opportunity for long-term wealth creation and insurance is a necessity.

The Parliamentary Standing Committee on Finance, examining the DTC Bill has suggested a hike in personal income tax exemption limit under the DTC to 3 lakh rupees p.a. and a hike in deduction in savings to 2.5 lakh rupees. With the DTC Bill likely to be delayed, taxpayers are anxious to see how many of these suggestions are reflected in the upcoming budget. The government’s finances, however, paint a different picture. The need to contain fiscal deficit might force the government not to give too much by way of a dole to taxpayers.

However, there is a school of thought which believes, and rightly so, that enhancing tax breaks and leaving more disposable income in the hands of tax payers will increase savings (much needed looking at the huge financing needed for planned investments) and boost consumption.

Moreover, personal taxes do not contribute much to the overall tax kitty. Hence, small benefits to the individual tax payer are unlikely to upset fiscal calculations. Let us hope the government is not oblivious to this fact.

As they say, it is always darkest before the dawn. Equity markets seem to be the finest proponents of this axiom. They have a habit of surprising investors. What we have seen so far in 2012 sums it up pretty well.

Rewind to December and it seemed that markets might fall into an abyss — falling rupee, rising inflation, tight liquidity, sovereign debt concerns in Europe, FII outflows, rising fiscal deficit and widening current account deficit made a perfect recipe for disaster. Fast forward to the present and we have seen the rupee recover by 10 pct from its lows, inflation down to 7.5 pct, RBI supporting the rupee and infusing liquidity by way of OMOs and a CRR cut, European Central Bank (ECB) on its way to infuse huge chunks of liquidity in the banking system, possibility of U.S. Fed keeping rates low through 2014, FIIs resuming their inflows in Indian equities and current account deficit being expected to narrow due to an import duty hike on gold imports.

Equity markets are up more than 15 pct in 2012 in a rally which at first looked like a short covering rally, but later, due to its sheer ferocity, has made some people think it may be the start of a more sustainable upward move.

Before commenting on whether the rally will continue, let us see what caused this rally. Was it fundamentals? Or was it liquidity?

Prima facie it seems like a liquidity driven rally that started on December 21, the day after the European Central Bank (ECB) lent 489 billion Euros to banks by way of LTRO (Long Term Refinancing Operations) for three years, to buy sovereign debt of troubled EU nations.

Today, markets have built in expectations of another trillion euros worth of liquidity infusion in the next tranche of the LTRO due on February 29. In terms of fundamentals, there have been some signs of hope both on the global as well as domestic front. Growth seems to have surprisingly revived in India as seen from the surge in HSBC PMI indexes in Dec 2011 and Jan 2012, whereas inflation has shown early signs of moderation. Even the RBI monetary policy stance seems to have turned pro-growth.

Will this continue? Your guess is as good as mine. With repayments of nearly 1.1 trillion euros due in 2012, neither can the EU afford to let Greece default, nor can it let yields rise prohibitively high so as to make refinancing impossible. Further, European banks have about $665 billion of debt due in the first six months of the current year, with a further $370 billion maturing by the end of 2012. In all probability, LTRO or backdoor QE, as one may call it, should continue for some time until Germany starts playing the role of hardliner once again. Liquidity environment is likely to remain supportive in the near term.

However, markets are unlikely to get much support from fundamentals in the near term as key indicators show growth moderating in the current quarter. On the inflation front, while there has been a temporary reprieve due to seasonal downside in fruit and vegetable prices, price pressures in high protein food items, fuel and power and non-food manufactured items still remain high and are yet to show sustained moderation. The RBI is also non-committal on easing interest rates, even though they clearly intend to ease liquidity.

What we have on our side in today’s markets is valuation. The other positive is the ‘expectations’ or ‘sense of disbelief’ in the market. To understand what might lie ahead, one needs to sense what’s going on in the investment environment.

One must be afraid of investor overconfidence, a high level of risk tolerance and a belief that risk is low. In contrast, one can take risk when investors are discouraged, risk aversion is running high, and economic difficulty is all over the headlines. Stocks have produced no gain for almost 4-5 years and no one’s excited about them, even though they are considerably cheaper. The ‘sense of disbelief’ in investment circles manifests from the fact that shorts have been built at every level in the current rally and mark-to-market losses are still being financed. Most investors today hold modest expectations for the markets.

Low valuations and investor indifference might mean that markets surprise on the upside. This makes us believe that the current rally might have some steam left in it as sentiments are not yet fully upbeat. Our stance remains positive for equities in the short term, though occasional pullbacks cannot be ruled out. A ‘buy on dips’ strategy should work well for equity investors in the near term. Valuations still remain attractive in specific pockets making it a perfect time for selective stock pickers following the bottom-up approach for stock selection.

Key risks to the above outlook might arise from surprise deterioration in the situation in Europe, the probability of which seems to have abated in the near term due to massive liquidity infusions from ECB. Apart from the above, results of upcoming state elections, mainly Uttar Pradesh, as well as the annual budget due on March 16 will remain the key factors to look out for in the near term. The RBI had clearly mentioned in its last monetary policy meet that any rate cuts in the near future will be contingent to the government adopting fiscal deficit reduction measures in the upcoming budget. Fiscal deficit is thus likely to remain the dominant theme in the upcoming budget.

What a year 2011 has been. Except certain commodities such as gold and oil, every other asset class has been hit. With Sensex down more than 20 pct YTD, 10 year g-sec yields up by almost 1 pct and rupee down by almost 14 pct against the dollar, it has been a poor year for investors. This was caused by a bout of strong global risk aversion led by the European sovereign debt crisis, high inflation in emerging markets and consequent monetary tightening, and lack of proper policy action in India. The only salvation came from commodities such as oil (up almost 26 pct in rupee terms) and gold (up almost 38 pct in rupee terms).

Are any of these likely to continue haunting us in 2012? Or will there be a new set of problems? Is the worst already behind us? That’s the million dollar question on everybody’s mind. The irony is few of us, if at all, have the right answers. Still based on evidence available today, one can hazard a guess.

What does 2012 have in store for the investor?
There is no doubt that growth has slowed down. The poor industrial growth numbers over the last quarter and the latest second quarter real GDP growth of 6.9 pct (manufacturing growth was a mere 2.7 pct whereas mining output contracted) drive the point home.

Is it going to change in a hurry?
Seems improbable. After all, more than a year of continuous rate hikes should have taken its toll on growth. And to top it up, inflation is yet to subside at least on a year on year basis, even though that is not the best way to look at it. The fall in the rupee hasn’t helped either, exacerbating the already high trade deficit and inflation by making imports costlier.

But aren’t we pricing it all in? Aren’t equity valuations cheap and yields already near 2008 highs?
True. But stocks can get cheaper still? Markets can remain irrational longer than you can remain solvent. Remember, we are still looking at Sensex valuations with respect to FY13 earnings which price in a 16-17 pct growth over FY12. Whereas FY12 earnings growth is already being revised down to 10 pct, expected FY13 growth can be downgraded further if macro indicators worsen.
Also, the Sensex earnings yield (basis forward PE of 13-13.5 as per FY13 earnings estimate) at approx 7.5 pct is still short (approx 0.8 pct) of the one year bond yield. Historically, equity markets have come out of a bear phase once Sensex earnings yields have been higher than bond yields by more than approx 50 pct i.e. the ratio between Sensex forward earnings yield and bond yields has been around 1.5. On this basis, valuations seem to be in a fair zone rather than being screaming cheap. For Sensex yields to become 1.5 times of bond yields today either the Sensex will have to be de-rated further or the bond yields will have to come down significantly. It is unlikely that either of these events happen in isolation. Rather a combination of both, i.e. a price or time correction in stocks coupled with the bond yields coming off significantly seems to be a more plausible scenario going ahead.

The initial part of the year 2012 (probably the first half) thus might continue to see high volatility as a result of the above. But as we move to the latter half of 2012, things should start improving. Bond yields are most likely to have come down quite some distance by that time (assuming that inflation moderates — month on month growth momentum in core WPI inflation is already showing signs of slowing down — and RBI starts cutting rates) and equities should be available at a real bargain by then. The second half of 2012 should thus be much better than the first.

What should investors watch out for in 2012?
Key risks to the above outlook might arise from adverse developments in the outside world including but not limited to the worsening of European sovereign debt crisis, a recession in the U.S. and Europe or a drastic slowdown in Chinese growth. Each one of these events will have the potential to give rise to a renewed bout of global risk aversion which will not be healthy for countries like India that depend on foreign capital flows to fund their current account deficits.

However, the key is still with Indian policymakers. Nothing mentioned above will be able to bring us out of the quagmire we have let ourselves in, if our policies are not right. Chronic diseases such as high fiscal deficit, lack of proper infrastructure and policy inaction have to be cured if we wish not to remain at the mercy of foreign capital flows. Foreign investors’ confidence in the India growth story, which has taken a beating of late, has to be rebuilt or reignited at any cost. Doing business in India has to be made easier to attract FDI and generate enough employment to harness the potential of favorable demographics. Otherwise, the advantage could soon turn out to be a disadvantage.

What should the investors do?
Investors should be wary of getting caught on the wrong foot as most of us did in the early part of 2009. Avoid selling at the lows. The first half of 2012 might give you a big opportunity to buy, though it is tough to correctly guess the time when that opportunity will arise. Don’t put your money in illiquid investments or investments with lock-in periods if that money is meant for equities. You don’t know when you might need it.

Likewise, staying on the sidelines might not be the best thing to do in these circumstances. Staying invested in markets is as important as anything else for long-term wealth creation, though you might choose to go underweight or overweight in accordance with the fundamentals. And this is surely not a time to go underweight on equities. Rather it is time to stagger your investments over the next six months and build your portfolio by way of STPs or Systematic Transfer Plans from cash to equities.

Just sticking to your asset allocation can help
Sticking to the original asset allocation will be of great help in the long run, in the scenario that might unfold in the near future. For instance, if one is supposed to invest in equities to the extent of say 60 pct of the portfolio, let him maintain that asset allocation at present. Under the above strategy, further downsides in equities will lower the allocation. The investor should then proceed to buy more equities to bring the overall equity allocation back to the original. This will automatically bring down the overall cost of equities in the portfolio and enable significant gains once equities bounce back.

Key triggers that can make the markets rise again
Even though the environment remains less conducive for a rally in equities, there is a lot of embedded value in stocks which should make lower levels unsustainable leading to strong bouncebacks following downsides. In terms of triggers, strong policy action by the government to bring about structural reforms tops the list. It is heartening to note that some activity has already begun on this front, the recent decision to allow FDI in retail being a case in point. Apart from that a solution to the European debt crisis (they are able to find a ‘buyer of last resort’ for EU nations’ debt) as well as a moderation in domestic inflation coupled with a fall in yields also has the potential to trigger a recovery.

The BSE Sensex romance with the 16,000 level seems to have been rekindled, with the Sensex closing below it on August 26, after a gap of more than 18 months during which it touched a high of 21,109 (missing the all-time high of 21,207 by a whisker).

As is the case, when a key sentimental support level is broken, most experts on business TV channels (a strong contrarian indicator) started giving short calls on the market the moment 16,000 was broken. Why is the level so important? What does it mean for the near-term outlook for markets? What should the investors do now? These are some of the questions that must be roiling the mind of every equity investor in India.

For starters, the Sensex closing at 15,848 on Friday is the lowest weekly close after nearly two years. This means investors who had invested in index funds made only 1.66 pct p.a. on an average in the last two years (as on Aug 26). Those in diversified equity funds fared somewhat better getting 5.4 pct p.a. in large cap funds, 9.9 pct p.a. in mid-cap funds and 9.2 pct p.a. in flexi cap funds.

Though positive, these returns are dismal as compared to what is normally expected from equities. In real (inflation adjusted) terms, equities have hardly yielded anything as WPI inflation (and I am not even talking about CPI inflation) has averaged around 9 pct p.a. over this period.

Compare this with 31 pct p.a. from gold, more than 6 pct p.a. from money market and short-term debt funds, 6.75 pct from medium-term debt funds and 6-7 pct from long-term debt funds and one can see that equities have underperformed the other asset classes significantly. Isn’t it then time for stocks to start catching up with their long-term averages (theory of mean reversion)? After all, haven’t stocks proven over time they are the best when it comes to beating inflation and creating long-term wealth? Is it then time equities start outperforming other asset classes?

While the answer to the above questions is in the affirmative, this does not mean that stocks will start rising from tomorrow, as headwinds from global and domestic fronts continue to remain strong. A confluence of global and domestic concerns had led to this sharp fall in the first place and they are yet far from over.

Threats of a double dip recession in the U.S., sovereign debt crisis in Europe spreading to much larger countries such as Italy and Spain, rating downgrade fears for France, rating downgrade of Japan (to Aa3 by Moody’s), together form a potent weapon causing uncertainty and risk aversion in financial markets. Believers in the efficient market theory would argue that this was all priced in, then why such swift retribution in equities. The fall has been even sharper in Indian equities, despite the strong domestic consumption-led India growth story.

For starters, the financial markets had priced in very slow growth in the developed world and not a recession. The reluctance of the U.S. Fed to commit itself to a third round of quantitative easing (QE3) has worsened investor sentiments even though there are strong doubts on the efficacy of such programs as is evident from the results of QE1 and QE2.

Emerging markets such as India, China and Brazil, which were earlier expected to be the engines of global growth, have their own share of problems in the form of high inflation, higher interest rates and hence slower growth. Now questions are being raised as to whether the global economy can chug along at a pace of 3-4 pct p.a. in the current environment. Empirical evidence shows that equities seldom do well in an environment when growth is decelerating or is expected to decelerate. At best they move in a range and at worst, there can be a sharp correction such as the one that we have already seen over the last month or so. Risk aversion continues to be high, but surprisingly, this time the flight to safety does not seem to be towards U.S. Treasuries. U.S. dollar is not rising as used to be the case earlier whenever the volatility indices went high. The CBOE volatility index is upwards of 30 pct, but the dollar index is still languishing at around 74 levels. Do we have a new so called ‘safe haven’? A look at the price movement in gold, Swiss franc and Japanese yen suggests so. All three of these have risen sharply ever since global equities began their most recent march down, towards the end of July.

The recent fall in Indian stocks has thus been a part of the global trend. And it is almost impossible for stocks not to get affected by the global trend in today’s globalised world where money and news move freely across borders at the click of a button. Even though the Indian economy might be largely insulated to events in U.S. and Europe, the financial markets are not, a fact that has been proved time and again.

Still we start talking about the India growth story and why and how Indian equities should buck the trend at the slightest hint of trouble abroad. And this time, India has its fair share of domestic problems too. High inflation, lack of reforms (much was expected from the monsoon session of parliament), slowing investment growth, high interest rates, slowing manufacturing and service sector growth (IIP growth has averaged slightly above 5 pct in the first quarter of 2011-12 while service sector PMI shows signs of deceleration), fears of a large fiscal deficit, deteriorating trade deficit numbers and a slowdown in overseas flows, have all contributed to a decline in investor confidence.

Having said that, do we fear a recession in India? Unlikely to the extent that you can almost rule it out. However, recession fears in the developed world can continue to haunt India in the manner they have done of late, as equities get de-rated, exports turn sluggish, overseas flows just about manage to finance our current account deficit, thereby putting pressure on the currency, and so on and so forth. For India, the most conducive global environment at this juncture would be a muddle through global economy with developed world growth between 2-3 pct, low commodity prices and low real interest rates in the developed world. It is however tough to see all these happening together in the near term. Even if the developed countries such as U.S. and Europe were to try and revive their economies by doses of quantitative easing, the same will raise commodity prices too, which is again bad for India as its inflation will get out of control (as seen during QE2).

We have already seen high inflation forcing down the level of financial savings in Indian households to less than 10 pct of GDP, in 2010-11. Hence, even though we can boast of a savings rate of more than 30 pct, this can very soon decline if inflation were not controlled immediately. RBI might thus be quite right in adopting a hawkish stance even when growth is slowing down.

Summing up the outlook for Indian equities, the macro picture and sentiments remain very weak in the near term, the latter more so after the Sensex closed below 16,000 levels on Aug 26. Solace can be drawn from the fact that perceived risk continues to remain very high whereas actual risk (the risk of equity prices falling by a large quantum from here on) remains relatively low because of attractive valuations in some pockets. A ray of hope has also emerged from the withdrawal of Anna Hazare’s fast. This should enable parliament to take up some of the critical reform bills that were supposed to be taken up during the ongoing monsoon session. Aggressive policy action and a strong boost to infrastructure investments can provide the much needed kicker to growth, which should then be taken as a positive by markets. RBI policy also remains an overhang for the markets and a dovish tone or a pause in rate hikes on September 16, 2011 should help soothe sentiments — though I have seldom seen equity markets in a bull run when rates are being cut (as rate cuts are a decisive admission of slowing growth).

Looking at the micro environment, it seems that a lot of the negatives are already priced in in certain pockets such as midcap stocks in the infrastructure and banking space, though the same cannot necessarily be said about the large cap names in these sectors. Midcap stocks in sectors such as cement, road, port and power infrastructure, construction, banking, etc. are trading at throwaway prices. Of course, there are corporate governance issues with some of these companies, but for a bulk of them the main concern is policy inaction and higher interest rates. As interest rates peak (they might already have) and some strong policy action is seen in the near term (a distinct possibility) these stocks might present a very attractive investment opportunity.

These markets are a value investors’ paradise. For the first time in the last two years, the average one year forward PE level for the Sensex has come down to the attractive zone (13-14 times). In some sectors such as infrastructure, metals, oil & gas, materials and mid cap IT, it is even lower. As and when the situation stabilises and growth seems to have bottomed out (it cannot decelerate forever and we know stock markets have a knack of anticipating turnarounds before others), these stocks and sectors should get re-rated significantly.

The ideal allocation for equity investors should hence be as follows –

1.       Neutral weight on large cap funds

2.       Neutral weight on flexi cap funds

3.       Overweight on mid-cap funds

4.       Overweight on value style funds

5.       Overweight on infrastructure funds

Whereas, the investment strategy should be -

1.       Get a six month STP in equities and then hold it with a minimum 2-3 year investment horizon

2.       Invest lump sum amounts on dips below 16,000 on the Sensex, strictly with an investment horizon of 2-3 years

Technically, frontline indices such as Sensex and Nifty seem to have broken crucial support levels as they closed below 16,000 and 4,800 levels respectively. This is likely to result in most of the long positions being wound up and fresh short positions being built, signifying intense fear and to some extent a panic.

TIME TO BUY and HOLD with a 2-3 year investment horizon.

The job of a central bank is not enviable, at least not in a growth-obsessed economy like India. When it does not get hawkish enough, it gets termed as being “behind the curve”, and when it does get hawkish, we implore it to stop for fear of hurting growth.

The Reserve Bank of India (RBI) has been in a similar dilemma of late. On the one hand, rising inflation has forced it to raise rates, whereas on the other, industry captains (banks and business leaders) and certain sections in the government are calling for a pause in rate hikes.

What such people fail to recognise is the fact that growth is going to slow down anyway even if the RBI does not hike rates. High inflation brings down growth all by itself. Instead of asking the RBI to stop, one should think of ways to bring down inflation. There simply cannot be any trade-off between inflation and growth. The choice is clear — ensure price stability and growth will automatically come in an economy like India’s. For the central bank, price stability comes first and it should remain so.

Going back to the books, RBI has already raised rates 10 times starting March 2010, hiking repo rate from 4.75 pct to 7.5 pct and reverse repo rate from 3.25 pct to 6.5 pct. This makes it one of the most aggressive central banks in the world in terms of fighting inflation.

The fact that despite this inflation has refused to come down, points to the structural nature of inflation. The journey that began with high food price inflation in 2009 has culminated in high wage inflation which together with rising input prices, has led to a spike in prices of manufactured goods. And this is what the RBI is most worried about.

To add to woes, questions are being raised on the quality of inflation data that is being doled out. There have been consistent upward revisions in WPI inflation figures since July 2010. Inaccurate data makes the job of a central bank even tougher.

Going ahead, we expect the RBI to hike rates further by 50 to 75 bps over the course of the next one year (including a 25 bps hike expected in the policy meet on July 26). Manufacturing inflation is picking up (has risen to approx. 7.5 pct), commodity prices refuse to come down (crude prices are back above $95/bbl) and possibility of another round of quantitative easing in the U.S. (QE III) is emerging. Amid all this, we expect RBI policy stance to remain firmly hawkish/anti-inflationary at least in the near term.

Growth is indeed getting hurt in this process as can be seen from the deceleration in GDP and industrial output growth as well as moderation in the pace of credit growth. But inflation is yet to be tamed. Over the past year, most forecasts (including forecasts from some of the most eminent economists and policy makers) calling for a peak in inflation have fallen flat. The question now facing the RBI is price stability or growth? It seems to be going ahead with the former.