We started 2010 expecting it to be a year of dull, boring, range-bound markets. Unfortunately, our forecast has proved correct so far with the market moving in one of the narrowest ranges in the past 20 years. We continue to expect 2010 to be a year of market consolidation with a single-digit positive return (index target: 18,000).

We see three macro positives: (a) inflation has peaked and should fall from 10% currently to 5% by the year-end led by lower food prices post-monsoon and lower commodity prices; (b) the fiscal deficit will be sharply lower, led by the higher-than-expected $22 bn raised from 3G/BWA auction proceeds. We expect the central fiscal deficit to be 4.6% (aggregate deficit: 8%) against budgeted target of 5.5%; and (c) lower oil prices will help the current account deficit. We have cut our FY11 current account deficit forecast by 50 basis points to 2%.

Earnings growth strong, but downgrades likely: While the Eurozone crisis helps India?s macroeconomy, it hurts earnings, given that global commodities accounts for 55% of the earnings growth for FY11. We expect metals to lead to a 5% EPS (earnings per share) downgrade over next few weeks. Earnings should, however, still end FY11 at a near 25% growth after two years of flat growth.

Valuations, supply of paper to cap upside: Valuations of the market, at 16x one-year forward earnings, are at a slight premium to long-term averages. In the Asian context, India looks expensive, partly justified by its insulated growth. Supply of paper should be strong this year and cap upside. We expect the supply of paper to be around 2% of market cap ($25 bn), led by PSU disinvestment.

Our model portfolio continues to favour domestic plays over global plays. We are adding marginally to our existing O/W (overweight) position in financials as bond yield fears ease. We also continue to O/W autos, capital goods and pharma.

Inflation has peaked: Inflation has peaked and should come off from 10% in June to 7.5% by September and 5% by March 11. Normal monsoon should douse inflation. Besides, the bulk of inflationary pressures?including pass-through from rising global commodity prices and Delhi?s administered price hikes?are to be taken into account.

The only incremental pressure left is the pass-through of higher domestic steel prices to machinery prices.

Industrial growth strong; to peak off by year-end: The recovery continues to surprise on the upside. The IIP (index of industrial production) growth for April came in at 17.6%, way above expectations. While we continue to expect a strong growth ahead, we expect industrial growth to slip to single digits by end-2010.

FY11 earnings growth to be strong: We expect earnings for FY11 to be strong partly helped by a flat earnings growth for two years. Our current analyst estimates indicate an earnings growth of about 29% in FY11 for Sensex companies. However, our top-down view is that Sensex companies should show a growth of near 25% for FY11.

The strong earnings growth for FY11 is largely led by global commodities prices. Close to 55% of FY11 EPS growth for the

Sensex is contributed by the commodities basket. Ex-commodities, the growth in Sensex earnings falls to a more sober 18% growth. Cement, telecom and consumers are expected to drag the earnings in FY11.

Earnings upgrades have not happened over the past ten months with FY11. With the recent softening of commodity prices, we may see some earnings downgrades for the commodity stocks.

Secondly, sensitivity of a 5% drop in profits for a metal company, for example due to a drop in metal prices, is more than the corresponding gain to a user industry like auto or engineering. Therefore, we believe that the FY11 Sensex EPS may come down to Rs 1,000 from our current estimates of Rs 1,050.

Valuations have come down from the recent highs: This is thanks to time correction currently witnessed by the markets and strong growth of FY11. On a P/E (price-to-earnings) basis, the market is trading at 16x one-year forward earnings, a slight premium to the long-term average. Similarly, on a P/B (price-to-book) basis, the market is trading at around the long-time average of 2.8x. However, in case earning downgrades come, then markets would become more expensive than they are currently.

Despite the recent correction, India is trading at a premium to the region. We think India deserves a premium, given its relatively defensive and domestic growth story. However, the premium appears high at the moment when we are expecting earning downgrades in the near future.