The year 2011 has been one of the worst in the history of the capital markets. According to Vikas Khemani, president and co-head wholesale capital markets, Edelweiss Financial Services, policy reforms along with fiscal consolidation will be needed to change the market mood. In an interview with Ashley Coutinho, Khemani warns that foreign exchange losses are likely to pile up in the third quarter of this fiscal, which could hit corporate earnings hard. Excerpts:

What is your outlook for Indian equities?

The year 2011 was almost a perfect tempest both globally and domestically. We saw deterioration in economic fundamentals (inflation, GDP, interest rates, currency and IIP), political environment, and corporate earnings. Sentiments have visibly hit the rock bottom.

To recoup growth environment will require a whole host of measures; we need fiscal consolidation and policy reforms targeted at boosting investment activity along with monetary measures to change the market mood. The cost of capital which has gone up significantly with sustained monetary tightening will have to come down as well. The good thing is that the central bank has indicated that we may have hit the peak of the tightening cycle.

Given the weak sentiments, I think we are about to start from a lower base with muted expectations. I feel that 2012 will be a year of moderate performance by equity markets unless the global front springs a nasty surprise.

How do you see the earnings growth this quarter?

It will be a disappointing third quarter. One reason would be the sharp rupee depreciation; from 47-48 levels, the rupee has depreciated by about 9% versus the dollar. So, foreign exchange losses are likely to pile up this quarter , which will hit corporate earnings. The next two quarters will be challenging as well. I would not be surprised if the earnings growth for FY12 hits ground zero. To a great extent, earnings downgrades have been factored in by the market. Still, there might be some companies that could surprise on the downside.

Can our consumption growth story come to the rescue?

The consumption growth is slowing down as well. Consumption in rural areas might be steady, but is clearly weakening in cities and mid-tier towns. Job losses are rising gradually in urban areas and that will erode earnings power. If the earnings power gets impacted, then consumption is bound to take a hit.

What are the key positives that could breathe life into the markets next year?

I hope that inflation eases soon and the central bank begins cutting key policy rates. If the price of crude oil falls and settles at sub-$100/bbl levels, it will be good for India. Besides, stability on the rupee front is critical coupled with good FII inflows. Also, one must remember that the market has withstood a lot of turbulence in 2011. From the sovereign debt crisis in euro zone to scams and to the steepest ever monetary tightening by RBI in a single year, there were several dark clouds around.

Will FIIs make a comeback in 2012?

It seems unlikely in a big way. FIIs will put in money only if our macro indicators turn favourable. They will scan all the key numbers ? GDP, IIP and earnings. If these numbers do not improve soon, they will stay away. But, I do not expect any significant outflows in 2012 as the market has retreated significantly this year, probably factoring in most of the negatives for the year ahead too.

How do you see the situation panning out globally?

It really depends on how Europe comes about. What complicates the situation is the fact that the problem is a political one. There is a possibility of large-scale defaults even as the collapse of the euro seems imminent.