There?s more heft in the macro now

The fundamental problem with the country?s macro indicators has been:

* Real rates are negative, as any normalisation of interest rates requires sustained tightening;

* Inflation is near double-digit, and, therefore, no real flexibility in sustaining the surplus liquidity policy for any length of time;

* India?s fiscal deficit is still high with targeted reduction based on 3G licence sales, disinvestments and oil subsidies remaining low (read: hoping oil prices remain low); *) dependence on global capital flows?equity, FDI and debt?to bridge a relative current account deficit. This has collectively been a significant overhang, and until fairly recently, seen signs of deterioration (ex capital inflows).

Last month or so, however, macro headwinds have seen a relatively dramatic easing. It?s not a tailwind just yet, but we do sense a distinct easing of the macro burden. This is across inflation trends and expectations, trajectory of rate increase expectations and pressures on the fiscal deficit. Collectively, we believe this is meaningful. The dependence on global capital flows has, however, increased and could well raise the volatility and vulnerability of the markets. This is a risk downside, but upside too, but is partly mitigated by the fact that markets?rather than the real economy?are more linked to the global environment.

Inflation and interest rate risks: Signs of inflation are peaking, and a high base effect up ahead, should ease pressure on RBI to do something. We still expect sustained interest rate hikes over the course of the year; 75 bps over 2010, but the risk that the scale and timeframe is accelerated has likely waned. Our economist Rohini Malkani recently revised down her inflation target for FY11 to 7.4% from 8.4%, and now expects rates in H1FY11 to rise 50 bps vis 100 bps previously. Mind you, inflation will still be high and rates will still rise, but the pace and level of these changes have shifted materially.

Fiscal deficit: The bumper 3G telecom licence auctions are proving to be a bonanza for the government and will help bridge the fiscal gap. The risk of an overshoot on targeted deficit remains, given the aggressive disinvestment targets. But there is cash to spare for the moment. Oil prices remain the wild card, but at most current oil prices, the commodity will not add to the burden. Our economists suggest India is actually in a position to beat its targeted fiscal deficit, given 3G gains, but we wouldn?t count on this just yet.

Hold the macro: India?s micro business environment is in good shape. We argue this on the back of:

* Decent demand: sales growth rising and in double-digits,

* Rising returns,

* Rising cash flows, and

* Rationality: reflected in returns, cash generation, and most importantly, in our view, in the corporate sectors more balanced approach between growth / returns and risks, something missing in the halcyon days of 2006-08.

It’s not all a one-way street, though.India?s earning revisions momentum is trending down and we expect it to remain tepid for a while. India?s earnings exposure to commodity-linked businesses is high. But corporates are generating cash after an investment binge.

Valuations are no longer expensive: India has over the last decade tended to be a relatively expensive market; averaging a one-year FWD price-to-earnings (PE) multiple of about 15X, and a price by volume (PBV) of about 2.8X. We believe these relatively higher (than regional peers) valuations were justified by the a higher growth profile, ten-year market earnings per share (EPS) compound annual growth rate (CAGR) at 32%, higher return profile, average return on equity (ROE) 20%, and possibly by a little more controlled access to the market (no longer the case).

The valuation range of the market has also tended to be relatively wide ? PE range of 9-22x, and a PBV high low of 1.5-4.5x. With a more supportive macro, and sustaining micro, we believe not withstanding the global uncertainties, the Indian market should trade at its long-term average market multiple (15X one-year Fwd, June 11), or 18,100 on the Sensex, and 5,450 on the Nifty, for December 2010.

Our previous target multiples for the market was also 15X, but benchmarked off September 2010, and earnings have since been upgraded meaningfully.

We believe the market could trade higher?but that would require a more decisive turn in the domestic macro, and atleast a stable global flow environment. Downside target risks would lie in either the macro or micro faltering (or a combination), or significant global uncertainty, particularly on capital flows.

We see market upside and now overweight the financials, (private banks) and capital goods. We remain negative on materials and cut IT services to underweight.