Sensex and Nifty at record highs, the Indian Rupee rallying sharply and bond yields falling are the market reaction to a resounding win for the main opposition party BJP in the just concluded state elections. In December 2013 Markets believe that BJP will come into power in the 2014 general elections and will wipe away all the ills of the economy.
The function of the markets is to believe what it wants to believe. In a bear market it will factor in the worst even if some factors do show signs of turning around while in a bull market, markets will factor in the best, even if those factors show signs of unsustainability. For example, at levels of Rs 40 to the USD in 2007, the INR was factoring in sustained growth for the Indian economy while at levels of Rs 60 in 2013, the INR is factoring in a long period of slowdown.
Markets now want to believe that a new government ( there is high uncertainty there as well given Indian voter fickle mentality) will take all necessary tough decisions to put the economy on track. Tough decisions to be taken include wielding an axe to subsidies and tax sops, going after wilful defaulters that have more than doubled banking system non performing assets, bringing down inflation that has given rise to resentment of the present government by the average India, build infrastructure, prick real estate bubbles, stop crony capitalism and weed out corruption, strengthen labour laws, increase public sector efficiency and productivity and a whole host of factors that has taken the economy back by at least ten years.
The question is, will BJP, if it does form a government at the centre in 2014, have the will, foresight and strength to take tough decisions that can be near term negative but long term positive? Indian economy is a series of near term policies, irrespective of which government was ruling at the centre. Tough decisions are taken only when economic conditions and markets force the decision on the government.
Ironically the UPA government woke up from a slumber when the INR touched record lows in 2013 and started to take some tough decisions such as containing fiscal and current account deficit, opening doors to foreign investments in Retail and Airline sectors and focusing on inflation. However UPA that had ten years to do the right things for the economy, has woken up too late.
The Indian economy and financial markets are not anywhere close to getting out of the woods. On the economic front, growth is at decade low levels, inflation is stickily high, interest rates have jumped up by 200bps after INR touched record lows, fiscal stress is high with government struggling to keep deficit at 4.8% of GDP levels amidst falling tax revenues and subsidy bill continuing to mount on high oil prices and food subsidy bill that was passed a few months ago.
Financial markets have to contend with the prospects of the Fed stopping its asset purchase program, debt overhang in almost all major countries of the world, rising interest rates in China, weak growth in Eurozone and below trend growth in major emerging economies including Brazil and India. Markets have started to do better with equities at record highs in many parts of the world but for high levels to sustain, economic stability is a key factor.
Investors should not give in euphoria but can definitely live on hope. At this point of time, hope is driving markets but going forward markets will want that hope to be realised and if that does not happen, the fall from highs can be pretty sharp and disastrous.