Biggest impediment to a roaring bull market is the state of domestic liquidity
The year 2012 was about defensive and quality stocks. We think this is changing – 2013 may look different. As usual, change is permanent even though changes are not. The earnings cycle is likely to inflect positively, setting the stage for: (i) higher equity prices; (ii) growth to beat quality; (iii) cyclicals outpacing defensives; and (iv) stock picking yielding to sector approach in equity portfolios.
Most of 2012 was about global factors: This was best evidenced by the all-time high that correlation of returns between Indian and global equities hit. Through the year, market participants argued for lower share prices premised on India’s poor macro backdrop. India’s high external deficit hinged it to global outcomes, making global rather than local factors the primary driver of equity returns. QE has stemmed India’s tail risks from its macro imbalances and coupled with a bit of domestic policy progress, return correlations have begun to decline, albeit from a historical high.
For 2013, we see the following:
* A new earnings cycle—A steady recovery in broad market earnings growth to 20% by end-FY2014.
* 26% Sensex upside—largely from earnings progression, not multiple expansion.
* An upcycle in earnings, strong global liquidity and supportive valuations are helping the market. Domestic liquidity and flattish yield curve are still impediments.
* Preferred portfolio strategy: Growth over quality (high free cash flow, high return on equity, low capex), cyclicals over defensives, active sector positions vs. stock selection.
Key assumptions: No major risk-off in the world, small domestic policy tailwind, elections not before year end, range-bound crude oil and front-ended rate cuts.
Our probability-weighted outcome for the BSE Sensex is 23,069 for December 2013, implying 26% upside.
Base case (60% probability): Sensex: 23,097. Fiscal prudence, steady improvement in infrastructure spending and progress on GST (goods and services tax), no major global risk-off with range-bound crude oil prices, reasonable capital flows and steady monetary easing on the back of slight moderation in inflation. Slower global growth will be beneficial for corporate margins in India as well as inflation. Sensex earnings growth at 10% and 19% for FY13 and FY14, respectively.
Bull case (20% probability): Sensex: 28,137. Global calm and a measured recovery in global growth, strong policy action, range-bound crude oil prices and rate cuts in response to a fall in inflation in Q1FY13. Sensex