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The Bharatiya Janata Party’s (BJP’s) showing in the state elections strengthens the hope in the markets that a Narendra Modi-led government will take office after the general election next year. This increased confidence should result in a boost to equity markets in the run-up to the general election, as investors position themselves for what they consider a more market-friendly government at the centre.

The overwhelming majority in the markets want a Modi-led government to take power next year. They are fed up with the growth slowdown, the targeting of businessmen and foreign investors, the lack of direction in policymaking and the clout wielded by the left-wing of the Congress party. Modi, on the other hand, is viewed by market participants not just as business-friendly, but also as a leader who is able to get things done. Many domestic as well as foreign brokerages have said that a Modi victory will be positive for the markets and the exit poll predictions had buoyed the Indian equity market last week. Citi Research says that regional funds that were underweight India are trying to go neutral to prevent taking a call on the general election. That trend should now be reinforced, with more foreign institutional investor (FII) funds flowing in.

Of course, that is not to say there’s no need for caution. The good show by the Aam Aadmi Party (AAP), for instance, introduces a new element of uncertainty, especially since their leaders are now talking of taking the party national in the general election. A note on the election by Bank of America-Merrill Lynch says, “Past experience suggests that these elections are important in boosting morale of the party and attracting allies. However, the connection between the performance in these state assembly elections and the performance in the general elections at the national level is weak. For example, BJP performed really well in 2003 assembly elections, winning three of four larger states but lost the general elections at the centre in 2004." But then, this is not 2004 and the disenchantment with high and persistent inflation combined with a lack of jobs has led to a strong anti-incumbency mood against the Congress. However, any adverse news will be seized upon as excuses to book profits, increasing volatility.

It isn’t just the equity markets that will react favourably to the state election results. The rupee too gained sharply after the exit poll results came in, in the hope that FII inflows will rise. Recent FII trading activity shows robust net inflows into equities. A big source of uncertainty—the tapering of bond purchases by the US Federal Reserve—persists. Recent strong economic data out of the US has strengthened the belief that tapering will begin soon. The key to the market reaction about the taper is whether it believes the US economy is strong enough to withstand the reduction in the monetary stimulus. Friday’s positive US market reaction to the upbeat non-farm payroll numbers suggests that is indeed the case. Moreover, the Indian economy too is now much better placed to withstand tapering, with the current account deficit having been slashed and with foreign deposits flowing in.

That’s not all. The worse seems to be behind us as far as the economy is concerned. With a depreciated currency and with demand picking up in the US and Europe, our exports have been doing very well. The good monsoons will bolster rural consumption. And higher global growth will provide a tailwind for growth in India as well.

Several states have notched up high rates of growth and the removal of political uncertainty will add to investment there. Why shouldn’t companies invest in Madhya Pradesh, with real state domestic product growth at 10% in 2012-13, or in Chhattisgarh, with a growth rate of 8.6% in 2012-13? Or in Delhi, with a 9% growth rate? As a note by Credit Suisse points out, “That the growth of state GDPs relative to the overall Indian output is so sharply divergent over the past 20 years is proof enough that just central government policies do not really have that much of impact on growth."

Nevertheless, the domestic economy remains very weak and there are few signs of improvement in the crucial factor—investment demand. Both inflation and interest rates remain high. The necessity of keeping the fiscal deficit low will mean that government spending will be low and that will take its toll on the economy. Anecdotal evidence about companies complaining about the government’s unpaid bills is readily available.

However, several central projects are stuck at various stages of implementation and if solutions can be found, that could immediately improve growth. The present government has been talking about giving the necessary clearances, but progress on the ground has been disappointing. The hope in the markets is that a new business-friendly government will lead to greater business confidence and to the return of animal spirits and investment demand. While that is likely to happen only after the elections, the markets will increasingly start pricing it in. That is why the cyclical stocks have been running up.

In short, the lead indicators now point to improved sentiment in the market. While its dependence on FII flows will ensure that global factors will matter the most, the stage has been set for outperformance by the Indian markets.

Manas Chakravarty looks at trends and issues in the financial markets.

Your comments are welcome at capitalaccount@livemint.com

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