The Indian stock market has outperformed global peers in the four years since the Narendra Modi-led National Democratic Alliance (NDA) government came to power.

Between 26 May 2014 and 23 May 2018, benchmark indices Sensex and Nifty rose 38.95% and 41.73%, respectively. While MSCI India rose 32.64%, MSCI Emerging Markets rose 9.6% and MSCI World 24.9%.

Abundant liquidity drove the domestic markets following the centre’s demonetization move.

“At the Nifty level, the market returns may seem unspectacular, but several stocks, especially in the small- and mid-cap space, have been multi-baggers in the four-year period," said Pramod Gubbi, managing director and head of equities, Ambit Capital. “A large part of the rally has been driven by fund flows supported by a benign macro, resulting in a re-rating of stocks, rather than any meaningful pick-up in earnings growth. Fund flows were also helped by the financialisation of savings accelerated by demonetisation and the relative unattractiveness of real estate as an asset class."

Market capitalization of companies listed on BSE rose to Rs145.10 trillion, surging 73.24% from Rs83.76 trillion on 26 May 2014.

According to Gautam Duggad, head of research, Motilal Oswal Institutional Equities, the markets did well, given the expectations of earnings recovery, consistent reforms and decision-making. Before 2014, policy paralysis and lack of meaningful reforms had been a damper. “However, disruptive and transformational reforms such as GST, RERA, IBC and demonetisation did impact the performance in the short term," he said. “But what helped in the last four years was the consistent and steady inflows of domestic investors in mutual funds. Mid-caps have done quite well in this four-year period and are now trading at a premium to large-caps."

Foreign investors have also been investing in equities, riding on the reforms agenda and macro stability, while domestic institutional investors (DII), including mutual funds and insurance companies, pumped in record numbers in 2017. Indian shares worth Rs40,803.55 crore were bought by DIIs, while foreign institutional investors (FII) have so far pumped in $477.23 crore into Indian equities in 2018.

Gautam Chhaochharia, head of India research, UBS, said: “The markets have done well under Narendra Modi, as investors have been impressed with the reforms agenda and efforts to improve the macro stability on inflation and fiscal front."

Deteriorating macros, high crude prices and a falling rupee could be key challenges for the markets amid high valuations, said analysts. The rupee has fallen 6.6% this year, while Brent crude prices are hovering around $80 a barrel.

“Now this Goldilocks macro is reversing with inflation rising due to commodity prices rallying, twin deficits and this has adversely affected foreign flows," Gubbi said. “With the US treasuries yielding north of 3%, it is hard to see foreign flows coming back strongly anytime soon. Even local flows have seen some slowdown. Earnings growth, which was expected to pick up, is also hit by input costs going up and margins getting crunched. Valuations are not cheap either."

Chhaochharia agreed the valuations were still very rich, given that the ratings were helped by low interest rates. He expects earnings cuts of 9-10% for Nifty companies in FY19. “Earnings are reviving. Even after the 10% cut, Nifty earnings are expected to grow at 13% in FY19, which is much better than its performances of the last few years," he said.

Duggad was cautiously optimistic as he believes earnings recovery of FY19 would ensure valuations do not de-rate much from here. “The clean-up of the banking system is almost reaching a closure and micros are picking up well," he said. “Consumption is on a rebound, autos’ monthly numbers are healthy and there are early signs of industrial capex recovery."

“However, while there is not much room for further price-to-earnings expansion, the prospect of earnings recovery led by financials and consumer discretionary will keep the optimism intact," Duggad said. “From an index viewpoint, we don’t see much upside in the near term. But there are enough bottom-up stock picking opportunities in the market."

Deepak Ramachandra, head of sales, India Equities at Bank of America Merrill Lynch, remains cautious about the Indian markets, on account of concerns over an increased risk of a deteriorating macro environment and uncertainty regarding the outcome of the 2019 general elections. “Further, our estimation of global economic trends such as industrial and consumer confidence, capacity utilization, credit spreads and earnings revisions has peaked and India again is not insulated," he said.

On Wednesday, the markets tumbled on concerns of rising oil prices. The Sensex closed at 34,344.91, down 306.33 points or 0.88%. The Nifty ended at 10,430.35, down 106.35 points or 1.01%.

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