World capital markets have evolved from being first derivative of the economic activity to be among the

core determinants to the economic outcomes. The intertwined troika of currency, commodity and
capital remains a serf to a click and oscillate more frequently than earlier. Volatility is now a common
constant of the markets with a frequently changing sentiment anchor through the financial calendar.

Markets respond to fundamentals, liquidity and sentiments and pilot the expectations wave. Not long
ago almost everybody had written off India as a near basket case on the back of bad governance,
slowing growth, possible stagflation, worsening twin deficits and to top them all a weakening currency.
Most of these issues now seem to be a passé. The much talked about tapering is no longer a deep black
swan as it seemed initially.

Consumption functions as bedrock of sustainable growth in India’s economic model. Most of the
resultant deficits are funded by the capital flows, mostly foreign. While it is difficult to fathom the final
impact of a full blown tapering can have on the outflows from emerging markets (India being a part of
the asset class), India retains its sweet spot as a good mix of macro and micro story where the big cycle
investor inflows should more than offset the short term outflows in medium term.

Off late, the government has demonstrated a healthy response to a stressed macro environment where
the policy machinery has responded with initiatives such as Project Management Group (PMG) a
possible framework that can evolve as an enabling template for delivering fast track infrastructure
project. It has also extended its commitments to sustenance of measured and time determined soft
increases in fuel prices.

Political developments would dominate the sentiments and market performance in the coming months.
The recent election mandates in favour of growth and governance form cornerstones of things to follow.
The new government, irrespective of its form, shape and structure, would take its share in the early part
of the cycle to provide the necessary momentum. One also has to respect the reality that the two
decade fragmented politics has retained the commitment to reforms continuum albeit with varied
intensity.

As one meets the nervous corporates at the ground level, one can question whether the market has
extended its positivity to outcomes on both economic and political events. However, it was no different
during the last downturn, as well as during the time of frenzy, where business sentiments extend the
recency to immediate future with deeper intensity. One has to view the current slow-down as a short
cycle occasion within a longer cycle in existence for India.

As things stand, the markets are trading at a 15-year mean of around 17x earnings. The expected two
year earnings growth is around 12-14%. While cost of capital has marginally gone up, India is certainly
offering trough-cycle RoEs, which can recover in medium term.

FIIs continued their faith in Indian equities with net inflows of $20 billion in the CY13, while domestic
institutions sold $ 13 billion worth of equities. Most of the flows have been chasing a small universe of
large caps while rest of the market got neglected. But when there is an upturn in the cycle, mid-sized
companies will be the bigger beneficiaries. Currently, the entire mid and small cap space is looking very
attractive. The valuation gap between large-cap and mid and small-cap is fairly large relative to history.
Thus one would witness lot of mid and small cap indices are substantially lower than where they were
while the benchmark index reaches an all-time high. One can anticipate a correction in this divergence
going ahead. We believe, over the next five years this space offers tremendous opportunity. Some of
these corporates have witnessed the most painful phases of their existence. The pain period has caused
quite a few of these managements to revisit and rationalize their strategies. Some of them are trimming
down their cost structure; others are hiving off non-core businesses. The higher interest cost regime has
also forced a measured look at leverage. We feel most of the companies which have been able to
protect the balance sheet in this environment have enabled their businesses to participate in the next
cycle growth.

In terms of risks on the horizon, any abrupt reversal in monetary policy by global central banks can
create volatility. We must understand that lot of growth in the developed economies and to some
extent in the emerging economies has been mainly on the back of stimulus. We are yet to see how the
growth pans out once this stimulus is removed. This apart, there remain structural issues with Europe,
China and quite a few other emerging markets.

While this happens, the market would benefit from the cushion provided by two interesting
phenomenon –

a. An emerging trend on consolidation in quite a few industries (which brings stability of cash flows)
b. An increased appetite from the developed world behemoths (Diageo, Unilever, GSK.. to name a few)
to gobble domestic cash generating franchises, provide a cushion to the downside.

We feel the market is poised for a good long run with the concoction of bottoming out of the Macro
data, improving corporate profitability, committed policy regime, reasonable valuation, and sustained
commitment from long term foreign investor. We expect the market to provide abundant prospects to
participate in medium term growth opportunities at attractive value. The long term investors would get
rewarded for their patience, and discipline. Return of the domestic investor who has been absent in the
party thus far, can kick start a multi-year bull run.

The primary and fundamental driver for bond yields is always the trajectory of growth and inflation.
Other factors are secondary and technical

In the meanwhile, RBI’s policy stance in the recent past has been guided by volatility in Rupee and
inflation expectations. USD 34 billion in inflows under the swap window has brought stability to the
currency. With this, RBI has had to particularly focus on inflation of late with particular focus on
anchoring “inflationary expectations”.

Looking at the growth-inflation dynamics, as currency market stabilizes, one can expect unwinding of
RBI tightening measures and bond yields to soften going forward. RBI also would like that real rates
remain attractive for some time in order to boost savings and restrain consumption.
External sector pressures which impacted the bond market this year have receded with narrowing of
trade and current account deficits and increased inflows under the capital account. As a consequence of
higher base effect, lagged impact of tight fiscal and monetary policies, output gap, soft global
commodity prices and likely policy action to augment the supply side may result in significant
deceleration in the inflation in second half of the calendar year. However, the uncertainty surrounding
the monetary policy stance and smooth absorption of market borrowings given the huge bond
maturities could keep yields under pressure at least in the initial part of the coming year which should
set up a good inflexion point for bond rally for the follow up year.