Are elections creating a bubble in Indian markets?

Mumbai - Leading American brokerage Bank of America-Merrill Lynch today cautioned against excessivefear of the poll outcome as in 2004 and the over-enthusiasm of 2009, saying the market should look more at the global economic cycle and its impact on growth than who takes charge at the Raisina Hill after the hustings.

“We can only emphasise that the global economic cycle drives growth far more than who rules in New Delhi. It is for this reason we caution against extreme euphoria a la 2009 or utter despair a la 2004 on May 16,” a BofA-ML report said.

The brokerage also warned, after talking to over 20 equity and fixed income investors in Singapore last week, that the forex market players would be playing it safe and square off their positions before the polls.

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It can be recalled that the market saw a massive 15.9 percent sell-off in May 2004 after the surprise defeat of the NDA and a 15 percent Sensex rally after the emphatic re-election of the UPA in May 2009. On both the occasions, the market did not get the poll outcomes correctly.

In a report titled, ‘Will markets be third time lucky? Three big ifs: Polls, the El Nino, and the dollar’, BofA-ML India chief economist Indranil Sen Gupta said the consensus among equity investors is to go along the polls in the hope of a successive stable coalition.

However, “forex investors are more circumspect; most say they will square off before the polls to avoid the event risk,” Gupta said.

Gupta noted that in both the past two occasions, the market behaved irrationally: in 2004 it lost 15.9 percent even as growth was picking up and in 2009 it rallied 15 percent on the result day just before growth began to fall.

Gupta goes on to add that the real test for the investors will be impact of the three big ifs facing the country-the polls, the El Nino and the US dollar.

On the polls, Gupta said that though opinion polls place BJP in the lead, we also acknowledged that poll predictions went wrong in 2004 and 2009.

On the way the markets reacted after the 2004 results (15.9 percent fall and in 2009 15 per cent rally), Sen Gupta said it was primarily because it ignored the impact of the global cycle that has driven growth far more than who rules in the Centre.

On growth, he said economic expansion is far less sensitive to poll results than stock markets and it has gone up and come down in every political regime, broadly in tune with global cycles.

A global up-cycle pushed growth not only here but also almost across the BRICs. Similarly, a global downcycle has pulled down growth in the UPA II years.

“Our base case is of a weak recovery in growth to 5.4 percent from 4.7 percent in FY14 assuming political stability; and 50-75 bps of lending rate cuts and normal monsoons.”

The investment cycle also mirrors the global cycle although much is made of how capex slowed down because of “political paralysis” and delayed project clearances, he said.

“Investment picked up across the BRICs in the upcycle UPA-I years and has fallen across the BRICs in the downcycle UPA-II years. It is for this reason we do not see a turnaround in capex till 2015 when we expect US recovery,” Sen Gupta said.

The rupee has also been driven by the dollar rather than political regime in Delhi, he added.

On the rupee, Sen Gupta said, he continues to believe that the principal risk to the rupee comes from a potential rebound in the dollar, especially as it has weakened to 1.38 euro. Our forex strategists forecast the dollar at 60-65, he said.

“We don’t share the exuberant view that a stable government could help the rupee appreciate to 55 levels as there have been no clear evidence linking the rupee levels and poll outcomes, except in 2009 when it rallied 3 percent.

“Already the stock markets have received one-third of FII equity flows to Ems and it is difficult to see how capital inflows can be much larger given that the Fed is tapering. We have already factored in portfolio inflow of $25 billion in our BoP estimates assuming the election of another stablegovernment, like, 1999, 2004 and 2009,” he said.

PTI