believe sustainably, thus, reducing dependence on volatile external capital flows. Further, the Indian economyís interest rate linkage with that in the US is feeble at best, with very little of FII debt holdings remaining.
Changing paletteómarket upside: We do not expect a pick-up in the investment cycle in the next two to three years: most types of large-scale investments, with the exception of oil & gas, have a depressed medium-term outlook. Similarly, middle income consumption should stay under pressure as stagnant wages (stress in the formal economy) and high inflation mar consumption. This is being exacerbated by a delayed supply response in white-collar workforce (courtesy the boom till 2010), and the government's pay commission cycle (every ten years: next one due in 2016), as a third of the middle class is paid by the government.
However, we expect income growth at the bottom of the income pyramid to stay robust. Continuing expansion in rural roads and electrification and the spread of mobile phones is driving unprecedented change and job creation away from the big cities.
Sector weights in market benchmarks have already started to reflect this divergence: exporters, healthcare and consumption have snatched weights from industrials, materials and banks. This sector rotation has implications for both earnings changes as well as P/E multiples for the broader indices. While MSCI India P/E is 7% lower than its average, once adjusted for the change in sector weights over time, it is 15% below its adjusted average.
Changing indices also explain why the sharp economic slowdown has not driven earnings declines for market indices. We expect earnings downgrades to continue (upgrades to consensus EPS since Sep-13 have largely been the mark-to-market of USD-INR), but stay constructive on the broader market, and maintain our defensive portfolio positioning.
The current beta rally in our view is a sign that investors are turning neutral weight to avoid being whip-lashed on the day of the election results. We believe this rally is an opportunity to cut beta exposure, and not a sign that large-scale investment is likely to recover.
The unknown unknowns: Each year sees some new surprise that few had foreseen at the beginning of the year: almost by definition, these are low probability events but ones that if known in advance can help outperform significantly. We list a few for the next year: (1) a sharp fall in oil prices; (2) the INR appreciating to 55-56 against the USD; (3) strong