Finance minister, Pranab Mukherjee, sounded a confident note time and again this year that GDP growth would be 8.5% (and trending towards 9%), inflation would be down to 6% and the fiscal deficit — the gap between government expenditure and revenues before borrowings — would be well within the 5.5% targeted for the year. The numbers at least till the second quarter of this financial year suggests the economy is on course to achieve the projections. Monsoons were good. All that’s good news. Not because, everybody knew it, but in a world that is still worried about slow growth and the possibility of another downward spiral, India stands out like a beacon of robust optimism.
Given this forecast, there is a good chance that the government will be able to wind down the economic stimulus package of 2008-09 by the next budget as the growth impulses of the economy are holding up. It will also prepare the country for the next round of reforms like GST, Direct tax, Retail and Insurance. Honestly, the growth is already a bit too robust. The country is growing so fast that it is importing far too much. At last count, the current account deficit — the gap between imports and exports of goods and services that has to be bridged with capital flows — is well above 3% of GDP, and maybe even 3.5%. This is clearly unsustainable, and sooner or later the country will have to reduce this deficit by slowing down growth or increasing exports. The latter appears dicey in the current global environment, though not absolutely impossible.
At a 3-3.5% current account deficit, India needs foreigners to invest in India, and in all probability, there would not be any restraint of dollar inflows into the stock markets. However, foreign investor inflows have already crossed $29 billion and are heating up the bourses and which is rapidly feeding into other markets like real estate and gold. It is difficult to see how this is a good thing, since it can lead to externally-induced market and economic volatility. In May, when the Greek tragedy unfolded and the FIIs suddenly withdrew money, the markets keeled over. There’s no point holding economic sentiment hostage to hot money flows.
Given the fact, that the fiscal deficit has been bridged largely by one-time earnings like spectrum revenues and public sector IPOs, it is best to let the markets and the economy cool off a bit. But, clearly, we have many things going for us. A strong consumption-led growth surge, a reasonable social inclusion package that is giving the economy a fillip of its own, and buoyant tax revenues are some of them. The only thing that can ruin it all is bad politics and scams— of which there is plenty to go around. We will do fine as long as we don’t shoot ourselves in the foot.
Two years after the global financial crisis, the developed countries deal with the problem their way. US hopes to spend its way out of slowdown while Europe decides to cut costs and resort to austerity. Quantitative easing in the US has brought a flood of liquidity to Indian equity markets also as is evident from the $29 billion that has come by way of portfolio investments this year. The inflation that is supposed to happen in US due to Quantitative Easing is not happening there but it is happening everywhere in emerging markets and India is no exception. The FII and FDI dollars are inflating the Stock and Commodity Prices stroking the inflation in India. The biggest problem thrown up by capital flows is currency appreciation, which erodes export competitiveness. Intervention in the forex market to prevent appreciation entails costs. If the resultant liquidity is left unsterilised, it fuels inflationary pressures. If the resultant liquidity is sterilized, it puts upward pressure on interest rates which, apart from hurting competitiveness, also encourages further flows. The Indian rupee has appreciated by nearly 3.3% against the USD this year on the back of inflows of over $39 billion that has come through the FDI and portfolio route.In that context, it must be said that India has done relatively well in sterilising the impact of reserves growth on their domestic financial systems and preventing asset price bubbles so far.

Indian markets have done well in calendar year 2010. The Bombay Sensitive Index has returned 14.4% till date and Indian markets have outperformed developed markets for two years in a row. The performance gap between the narrow and broad market closed out in 2010 as compared with 2008 and 2009. Both the indices achieved comparable returns this year.

Technology and Telecoms were the best- and worst-performing sectors for the year. Financials did well. Sector rotation was higher than average. Consumer discretionary, technology and financials were market outperformers, while utilities, energy and materials were underperformers. Industrials delivered the most volatile performance during this year. There were many money making ideas in both the large cap and the midcap space all through this calendar year. Midcaps saw a correction of 25-40% in the 4th quarter this year making their valuations much more attractive.
I remain constructive on the market outlook for 2011. The strong economic fundamentals, reasonable earnings outlook and lower valuations are likely to provide downward support to the Indian equity markets in 2011. The fundamentals of the Indian economy remain strong, while the capex cycle is yet to pick up substantially. The outlook for growth in earnings remains reasonable and the recent market corrections have made valuations a bit more reasonable. Financials, Industrials, Commodities and real estate are expected to do better than consumer discretionary and consumer staples in CY2011. Midcaps would give better returns than large caps next year.
The key concern area in my view would be any shocks emanating from the developed world or the high domestic inflation. Notwithstanding, some positive signs on the economic front in the western world, the debt levels do remain high. I expect some more bad news coming out of Europe in the first quarter of 2011. On the domestic side, while inflation is expected to come down over the next 3-4 months, higher commodity prices or sticky manufacturing prices would be an area to watch out for.
Volatility is likely to continue in 2011 with the central bank fight against inflation keeping the markets guessing on the extent of further tightening. However, with the effective front loaded tightening by the central bank, market yields are already discounting a fair bit of inflation worries and more importantly real rates are finally moving into positive territory, I believe that returns from markets are likely to be attractive for investors with a medium term horizon. At current levels ours is an interesting bottom –up market. These are times to buy the growth companies managed by great managements, especially in BFSI, Auto, IT, metals and engineering sectors.