The Indian equity market is expected to stay volatile till the currency stabilises, says Ramanathan K, executive director & CIO, ING Investment Management. The Indian market, he says, faces significant domestic challenges, including fiscal concerns, corporate external debt vulnerabilities and national elections. In an interview with FE?s Ashley Coutinho, Ramanathan says the RBI governor?s focus on CPI inflation has added to rate outlook uncertainty. Edited excerpts:

What is your outlook for the equity market in the year ahead?

Given the continuing fears of abating global liquidity, currency stability has emerged as the overriding catalyst for the Indian equity market and until the currency stabilises, we expect the Indian equity market to stay volatile. The market seems to have ignored the fact that the US Fed has simply postponed the tapering of its $85 billion-a-month bond buy-back programme. We would not be surprised to see tapering back on the agenda of the US Fed in a few months? time, which could result in further volatility. The Sensex price-to-earnings ratio at about 14.2 times implies limited upside given the sticky domestic risk-free rates owing to the renewed hawkish stance in the credit policy and downside risks to earnings.

What is your earnings outlook for the coming quarters?

The Indian economy slowed yet again, growing by 4.4% year-on-year in the April-June quarter. We see little upside to growth for the rest of the financial year if liquidity tightness persists and sentiment remains weak. While the FOMC (Federal Open Market Committee) surprise and the RBI measures have prevented the rupee?s free fall, the ongoing structural adjustment and the resultant low growth will likely continue. In such a scenario, there are downside risks to Sensex earnings.

What are the key triggers for the market, going forward?

Currency stability remains the key determinant for equity market certainty. Recent announcements over the FCNR-B, supportive trade data and easing investment facilitation in debt markets have resulted in imparting long- needed and much-sought-after credibility over both the financing of the CAD and the actual CAD. Excessive fears over tapering and a tempering of the Syria risk have also assuaged investors, aiding inflows. While any potential weakening in US bond yields and reduced fears of an aggressive taper by the Fed will aid flows, a more sustainable return of faith will critically hinge on the government?s commitment to drawing a line on the fiscal deficit at 4.8% of GDP. Investors are keenly expecting a fuel price hike (both one time and a higher monthly calibrated hike) as an endorsement of the commitment to fiscal discipline. Also, any sharp fall in global oil prices will be a big sentiment booster for the currency and as a corollary, the Indian equity market.

What is your view on the interest rate trajectory for the year ahead?

Though not explicit, the RBI action in terms of increasing repo rate indicates that inflation focus is a priority. This may impact growth in the near term. The large difference in core inflation, WPI inflation and CPI inflation and the RBI governor?s focus on CPI inflation have added to rate outlook uncertainty. The current bond yields discount a further 25-50 bps repo rate hike. The trajectory of inflation will determine whether this expectation is delivered or not.

Do you see the currency strengthening going forward?

The RBI has essentially bought the rupee time; namely, time for the natural correction on the current account to play itself out. The progress on the latter has been encouraging, with the trade deficit narrowing from an average of $18-20 billion to $10.9 billion in August. A pickup in exports and a collapse in gold imports on the back of tighter restrictions have aided this contraction. RBI?s measures have been a welcome circuit-breaker in the near term. However, significant challenges such as the upcoming elections, fiscal concerns and corporate external debt vulnerabilities remain, and these are likely to be visited in the months ahead. We believe that if the trade deficit moves below $10 bn per month, and stays in the single digits over next few months, it will help stabilise the INR.

Bond yields have become volatile since July 15. Do you see the yields stabilising in the near term?

The 10-year bond yields have touched 8.80% levels from 8.10% levels pre-policy. Current levels discount a further 25-50 bps repo rate hike. Given the negative surprise in the monetary policy, poor sentiment and lack of appetite by market participants, the incremental supply would be difficult to absorb. This will result in continued volatility in bond yields. It remains to be seen whether the RBI would like to support long-bond yields through OMO purchases. The short-end bond yields, though, would come off over a period of time given RBI?s stated intention of calibrated unwinding of the exceptional measures taken earlier.

Which debt products do you expect to do well in the coming months?

Ultra-short-term and short-term bond funds are expected to do well in the coming months given the fact that the RBI is trying to unwind the extraordinary measures it took to protect the rupee in the last few weeks. FMPs are also likely to stay in favour given the high short-term rates.

What is your outlook for FII investment in India?

Between June and August 2013, India saw its sharpest bout of FII outflows of about $4 billion since the global financial crisis, leading to fears of a possible capitulation by FIIs, who now collectively hold close to 40% of the outstanding free float. Following incoming governor Raghuram Rajan?s announcements on assuaging currency markets and particularly after the newsflow over the FCNR-B swap announcements, we have seen the rupee partially recovering its losses and FIIs emerging as net buyers. While it may be premature to conclude if the worst of the FII selling is over, we highlight anecdotal data which illustrates that since the global financial crisis, bouts of sharp currency depreciation in India have generally been followed by periods of strong FII inflows into equities. What would be more crucial for continued FII inflows is outlook on the domestic economy. Delayed or uncertain recovery led by tight monetary policy or uncertainty on general elections could result in FII flow volatility.

What are the other global cues to watch out for?

Global factors that can impact Indian markets include the risk of tapering of the Fed bond buy back resulting in capital outflows, systemic crisis emanating from Europe or escalation of geopolitical issues in the Persian Gulf.