Volatility is expected to increase in Indian shares in the coming week as the nation awaits election results to five state assemblies as well as the possibility of a US rate rise this month. Market pundits say any big fall in prices would be an opportunity to grab bargain buys, with corporate earnings seen improving and swelling cash flows into domestic funds.

The voting ends on Wednesday after more than a month since it started in the multi-phased election and the counting of electronic ballots is scheduled on March 11. News channels and newspapers will begin releasing exit polls on Thursday, and these would have an influence on trading in the financial markets.

The most closely watched verdict is from Uttar Pradesh, home to more people than Germany, the UK and France combined. The largely impoverished northern state is crucial for Prime Minister Narendra Modi’s Bharatiya Janata Party (BJP) to make up for the numbers in the Rajya Sabha, or upper house of parliament, later this year.

A victory for the BJP would strengthen the chances of getting legislative approvals for reforms, and would trigger a stocks rally. However, it faces a tough fight from an incumbent regional heavyweight that has allied with the weakened, but relevant, Congress party. A third group, comprising the underprivileged and led by a maverick former chief minister, is also in the reckoning.

The other states in the polls are Punjab, Goa, Uttarakhand and Manipur.

Caution beckons

“There’s tension already in the air,” said equity salesman Anmol Bhushan. “The market has run up strongly on expectations for a BJP win. If that doesn’t happen it could knock five per cent off the market.”

Politics plays a decisive role in shaping economic policies in India. The BJP and its allies have a two-third majority in Lok Sabha, the lower house of parliament, but many of its legislations are stalled in the upper house where it does not have a majority. While members of the Lok Sabha are directly elected through national polls, it is state lawmakers who elect members to the Rajya Sabha based on proportional representation.

Both the top-30 Sensex and the 50-share Nifty snapped a run of five consecutive weekly gains, after rallying to their highest in nearly two years. The Sensex closed at 28,832.45, down 0.2 per cent on the week, after hitting 29,145.62. The Nifty rose to 8,992.50 before retreating to end down 0.5 per cent at 8,897.55.

Some brokerages say the market is anyway ripe for profit taking after the market rallied about 8.5 per cent so far in 2017, making India among the top two performing in emerging Asia.

“With no material change in earnings estimates and no visible evidence suggesting the risk of consensus earnings downgrades — seen over the past three consecutive years — is now firmly behind us, the liquidity driven expansion in valuations looks unlikely to sustain,” analysts at Deutsche Bank said in a report titled “Lights turning amber, time for pullback”.

“While we remain excited about the roll-out of the GST (Goods and Services Tax) in July, we see this impacting consensus earnings in 2H (second half) following the roll-out. The BSE Sensex is now trading at a 12-month forward P/E (price-to-earnings ratio) of 17 times (consensus), which is in line with its past five-year average.”

Waiting game

However, other factors and indicators show the outlook is improving on the back of easing cash conditions, stepped up government spending on infrastructure, consolidation happening in the manufacturing and services sectors, rising consumer demand and an overall feel-good sentiment.

Factory activity in February expanded for a second straight month, while an increase in raw material costs pushed companies to raise prices at the fastest rate in nearly three and a half years, a private survey showed.

The Nikkei Manufacturing Purchasing Managers’ Index, compiled by IHS Markit, rose to 50.7 in February from 50.4 in January.

“Indian manufacturers benefited from recovering demand and raised production volumes. However, with growth rates well below-par, the sector still has many areas to develop before it can fire on all cylinders,” said Pollyanna De Lima, an economist at IHS Markit.

Importantly, the dominant services industry returned to growth for the first time in four months as demand slowly recovered after the government’s abrupt decision in November to scrap high-value bank notes triggered a severe cash crunch and hurt activity.

In an era of rising protectionism global investors are looking to economies with large domestic markets.

“My long held view remains that India is the best domestic demand story,” CLSA equity strategist Christopher Wood told ET Now television channel. “I am betting on the capex geared areas and I am basically owning the domestic demand areas. These stocks are less impacted by any potential threat to globalisation.”

Indian shares make up more than half of CLSA’s long-only recommendations of about 25 stocks for Asia, excluding Japan.

“I own the stocks that were hit most directly by demonetisation but the good news for my portfolio is these stocks have rebounded strongly in recent months since demonetisation,” Wood said. Technically, there is probably a case to take some profits in some of these domestic names which have good runs but as this is a long-term portfolio, I am not going to do big profit taking.”

“I am continuing to focus in areas like financial. I am hoping and expecting that demonetisation will be a positive for the long-term promotion of use of financial assets in India and I am taking the view that the demonetisation initiative is a positive, not a negative.”

Key drivers

Heightened mergers and acquisitions (M&As) activity could become a major trigger for Indian stocks, driving their valuations and margins, according to investment bank Morgan Stanley.

“If history is a guide, M&A transactions could scale $100 billion in the next 12-months,” strategists led by Ridham Desai said in a report.

Sectors with the least pricing power or most distressed — banks, steel, infrastructure, cement, property and telecommunications — will be the most favoured for M&A, they wrote.

The investment bank raised its December 2017 target for the Sensex by 10 per cent to 33,000 on base case scenario, saying that it expected earnings revisions to pep up the market. On a full-blown bull run, the benchmark index could reach as high as 39,000.

“We lift our earnings growth estimates for FY19 from 15 per cent to 24 per cent,” the analysts wrote.

They recommended buying financials, property, steel, infrastructure, cement and telecommunication stocks. Energy conglomerate Reliance Industries Ltd has been added to Morgan Stanley’s Focus List at the expense of Sun Pharmaceutical Industries.

Reliance shares climbed to their highest in nearly nine years on Friday after brokerages CLSA and Bank of America-Merrill Lynch raised their 12-month target price by 10-14 per cent, citing earnings from the group’s Jio mobile services.

The writer is a journalist based in India.