India’s equity and currency markets appear optimistic about the country’s election outcome and, therefore, about policy action and growth implications in the coming 12 months. In the run-up to the nationwide parliamentary elections, the Sensex pushed into record territory.

But, to keep the market trending higher, this vote, heralded for its sheer size, will have to channel its enormity into a strong mandate for the winning party or major coalition. Such results could signal a sea change for India’s economy, which has struggled with stagflationary conditions in the last few years despite favourable demographics and significant potential for catch-up growth.

We see five key reforms that could re-ignite the country’s economy, pushing it toward sustainable 7-8 per cent growth in gross domestic product (GDP):

• Manage wage growth in line with productivity. Ensuring effective implementation of the rural employment scheme will put wage gains more in line with productivity and limit any inflationary effect, in our view.

• Cut the fiscal deficit to boost public saving, thereby lowering the current account deficit in a sustainable manner, while improving the mix of government spending towards more capital expenditure.

• Improve the business environment by providing a consistent policy framework in key infrastructure and industrial segments. We should also look at streamlining investment project approvals, facilitating corporate balance-sheet rehabilitation, recapitalising state-owned banks and promoting reforms to encourage workers to move into organised forms of labour market activity.

• Rethink policy to promote urbanisation, a key to productivity growth, as urban economies are typically more efficient and feature higher value-added job opportunities. Initiatives should focus on creating urban infrastructure and ensuring better delivery of public services.

• Finally, address structural rigidities in the economy to unleash growth potential, particularly in energy and mining, which are constrained by several supply bottlenecks, including the approval process for environment and land acquisition and a lack of rail links.

We have quantified distinct growth outcomes under four election result scenarios: an absolute majority (260+ seats) for the winning party; 220-230 seats for one of the two major coalitions; a more fragmented coalition with the lead party winning about 180 seats; and abroad fragmented coalition with participation of a lead party only in a supporting role.

We think an absolute majority could accelerate fiscal 2016 GDP growth to 6.5-7.25 per cent and raise market earnings growth to 25 per cent, but a broad fragmented coalition could cut these respective figures to 5.0-5.5 per cent and 5.0 per cent.

The earnings yield gap of the MSCI India, a free-float adjusted market capitalisation weighted index, suggests that the market believes a new growth cycle is imminent. But it believes that such a growth cycle hinges on a decisive election outcome.

Still, India has witnessed strong inflows from foreign institutional investors, in contrast to outflows for emerging markets; the average breakdown by sector for institutional portfolios suggests that investors have positioned themselves for a cyclical recovery, as they are overweight financials, industrials and consumer discretionary and underweight technology and health care.

If the elections are decisive, utilities, state-owned banks, energy, industrials and materials could gain the most. Credit spreads would likely tighten on the potential for state-owned bank recapitalisation, a better balance of payments in India’s international accounts and a more stable sovereign ratings outlook. The Indian rupee could appreciate another 7-8 per cent against the dollar.

If the elections produce a fragmented coalition, the equity market could revert to quality stocks; in this scenario, technology and pharmaceuticals could be the major outperformers, and the rupee could lose more than 10 per cent.

From a portfolio perspective, we believe investors should own a mix of stocks with global exposure and local cyclical businesses, those with a growth at a reasonable price orientation and some stocks in industries that could benefit from post-election policy action (such as energy).

Such an approach could insulate a portfolio against a fall in risk-adjusted performance, though it may not guarantee outperformance in the case of extreme electoral outcomes.

 

— The writer is the chief India equity strategist with Morgan Stanley.