J.P. Morgan - NDA sweeps the National Election. What next?

India Equity Strategy NDA sweeps the National Election. What next?

· BJP-led NDA coalition wins an overwhelming mandate. The much maligned opinion/exit polls got it right this time. In line with their estimates, the NDA alliance is poised to form the next government in Delhi, on the back of a sweeping mandate. The margin of victory was, however, significantly higher than expectations. The BJP, with more than 280 seats, has a majority on its own (the lower house of Parliament, the Lok Sabha, has 543 seats). With other coalition partners faring well too, the NDA alliance has more than 330 seats. This represents one of the most decisive mandates in a National Election since 1984.

· The strength of the mandate and the increased bargaining power it gives the incoming Government vis a vis other Parties and State Governments augurs well not only for better governance, but also meaningful policy reforms over the medium term.

· But financial markets’ response was relatively muted. Markets surged in early trade as the better-than-expected results trickled in. At one stage, benchmark equity indices were up 6%, the INR was up 1% and yields on the benchmark 10-year bond declined 9 bps. But, subsequently most of the gains subsided. Equities ended the trading session up a relatively sedate 1%. The bond markets in fact saw Yields on the benchmark 10-year Bond end 5 bps higher.

· The correction in equities could be attributed to a) Profit taking; remember equities were up 7% over the last week in the run-up to the results, and b) some sectoral rotation in favour of domestic cyclicals. Though the gains subsided in these sectors too late into the trading session.

· Separately, the recent rally has taken Valuations to a zone (nearly one standard deviation higher than mean) where they can no longer be termed ‘cheap’, although they are not in frothy territory yet.

Figure 1: MSCI India 1 year forward PER Input Title Here

Source: MSCI, IBES, Datastream

· What next? Going forward, we would expect to see an upturn in economic activity (a position we have held for a while), coupled with a better policy environment and governance. That said, we believe investors will have to reckon with the following:

a) While the NDA has an overwhelming majority in the Lok Sabha, it does not have a majority in the Rajya Sabha, the upper house of Parliament. This could potentially constrain the Government’s ability to pursue reforms that require legislative action, and underscores the imperative to reach out to the Opposition and build consensus.

b) Monetary and Fiscal policy could be constrained to tight over the near term. So even as medium-term economic prospects may have increased after today’s electoral majority, near-term challenges still bind (for more details please refer to J. P. Morgan Economics, India’s Election: BJP coalition on course to sweeping victory; Modi set to be Prime Minister; May 16, Sajjid Chinoy). It is pertinent to highlight here that Bond markets have not participated in the Equity markets’ enthusiasm over the last three months and the yield on the 10-year benchmark bond at 8.83% is only marginally lower than the highs of 9%. This would suggest that cost of capital remains a headwind for a full blown economic recovery, particularly one driven by the investment cycle.

· In this backdrop, we believe investor attention would now focus on the Government’s initial policy priorities to be announced over the next 1-2 months. Over the interim, our base case remains for equity market returns to be driven mainly by earnings growth (we currently estimates earnings growth of about 12-14% over FY14E-16E) subsequent to the recent re-rating.

· Sector Stance: Given the nature and extent of challenges facing the economy, we expect the recovery in the economy and corporate earnings over the near term to be relatively muted in relation to current market expectations.

· Consequently, we would avoid companies with high leverage or where expectations of a turnaround are premised on regulatory / political largesse. We would particularly caution against chasing beta in the financials (State-Owned Banks and NBFCs) and investment cycle space (private sector infrastructure conglomerates).

· Since the beginning of the year we have been advocating playing a potential economic recovery through high-quality Financials, Commercial Vehicles, Cement and Resources – Metals and Private sector Energy.

· We believe any policy reform by the incoming Government to kick start the investment cycle will initially have to start with the Resources sector. Reforms herein will be key to resolving bottlenecks in the Infrastructure sector and subsequently the Credit cycle in the financial sector. Note that Energy and Metals have been among the best performing sectors in the beta rally over the last few months.

Table 1: J.P. Morgan India Model Portfolio

Current	Portfolio Stance	Top Picks	Avoids
CONSUMER DISCRETIONARY	Underweight	Zee, Tata Motors	Hero Moto, Maruti
CONSUMER STAPLES	Neutral	ITC,GSK Consumer	Hindustan Unilever, Asian Paints
ENERGY	Neutral	RIL
FINANCIALS	Underweight	ICICI Bank, HDFC Bank	Second tier banks, NBFCs
HEALTH CARE	Overweight	Dr. Reddy's Lab	Apollo Hospital
INDUSTRIALS	Underweight		BHEL
INFORMATION TECHNOLOGY	Overweight	Infosys, Tech Mahindra
MATERIALS	Overweight	Grasim, Tata Steel, Sesa Sterlite
TELECOM	Underweight
UTILITIES	Neutral	Power Grid, Tata Power	Private Sector Infra/ IPPs

Source: J. P. Morgan

Table 2: 2014 Lok Sabha Election: Party wise Win and Lead

NDA			UPA			Other Key Parties
BJP	284		INC	45		ADMK	37
TDP	16		RJD	3		TMC	34
SS	18		NCP	6		BJD	19
LJP	6		JKNC	3		TRS	11
SAD	4		JMM	1		CPI (M)	9
Others	7		Others	3		SP	5
						AAP	4
Total	335		Total	61		JD(U)	2
						JD(S)	2

Source: Election Commission of India

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