THE run-up to the elections is the easier phase for investors, holding a high likelihood of giving positive returns. Investors buying six months before the elections made money in six of the last seven elections, with an average return of 15%.

Do elections matter?

Low co-relation between GDP, market performance and nature of government over a long term

If we look at the full term of each previous government, market performance has been mixed, with no clear link to the nature of the government. The worst performance of the markets during the past 25 years was during a minority United Front government in 1996-98, which is no surprise. However, we were surprised that the best performance came during the two-year rule of another minority government (National Front government) that saw two prime ministers in the period (VP Singh and Chandrashekhar).

The second-worst market performance has been during

Vajpayee?s NDA government (the BJP), which was a reforms-oriented period.

Of course, to some extent, this analysis reflects the fact that many factors?including global trends?impact GDP growth and the stock markets. Also, there are two more factors that impact this analysis: (i) Many state governments accelerate reforms in their states and hence are able to grow irrespective of central government policies; and (ii) Pro-economy measures normally show results with a lag. To that extent, quite often, reforms done by one government may reflect in GDP growth during the next government?s tenure.

But in the short term, elections do matter to markets: For this year, however, the nature and shape of the Government would substantially influence stock market returns. Typically markets have tended to do well in the first few months of the formation of a new government.

Opinion polls favour BJP: Opinion polls suggest the BJP-led NDA has been gaining support over the past few months. For forming the government any alliance will need 272 seats. Opinion polls published in the last month suggest NDA will get close to 230 seats, with the BJP getting close to 200 seats. With this trend, NDA would be within the striking distance of achieving a majority with the help of few of the smaller parties. On the other hand, opinion polls suggest the Congress-led UPA will have around 130 seats, with Congress party getting around 105 seats.

Among the other significant parties, opinion polls suggest the AIADMK will likely be at around 25-30 seats, Trinamool Congress around 30 seats, Left parties 20-30 seats, SP and BSP around 15 seats each and YSR Congress 10-15 seats.

So what are the government options?

Broadly, without getting into the parties themselves, there are two broad options of the nature of government post-elections:

(i) Stable coalition: The leading party in the coalition would have 150-200 seats and form the core of the coalition. They would need to seek the support of two-five regional parties (the lesser the better).

(ii)Fragmented coalition: This would be a government of many small regional parties in a post-poll formation. Historically, in India, this sort of government has lasted only two years.

Stable coalition scenario

(i) GDP growth recovers slowly: We think growth will gradually recover (a) a stable government improves consumer and business confidence (b) global growth recovers led by a US recovery (c) a stable rupee and falling interest rate provides room to cut rates and (d) the government is able to accelerate reforms.

(ii) Rupee appreciates: We expect $25 bn of portfolio flows to put appreciation pressure on the INR to R57-58/$. At the same time, we expect it to settle round the Rs60 levels as the RBI is likely to buy to recoup forex to push up import cover from 7.5-8 months to the 10 months needed for INR stability. Our global FX team also expects the USD to appreciate to 1.25/euro by December.

(iii) Interest rates fall: We are building in a 50-75 bps RBI rate cut by end-FY15 with a stable INR limiting imported inflation pressure.

(iv) Markets rally 5-10%: Markets are likely discounting a stable coalition. However, we still see a further rally in the next few months as reform expectations build up. We believe most of the rally will be led by valuation re-rating as market anticipates a turn in the economic cycle.

(v) Sector positioning in this scenario ? shift to domestic plays: We think a stable coalition and expectations of appreciating rupee will lead to a shift to domestic plays which are under-owned and have underperformed. We would have three themes here: high quality cyclicals (Maruti, ICICI Bank) (b) reform plays (ONGC) and (c) small exposure to beaten down deep cyclicals as a tactical play, including infrastructure and PSU banks (Jaiprakash and State Bank).

Fragmented coalition scenario

(i) GDP recovery stalls: In spite of tailwinds from a strong global growth, we think GDP growth in FY15 will stall below 5% as (a) business and consumer confidence remains weak and (b) reforms are difficult to implement.

(ii) Rupee depreciates: Political uncertainty could lead to portfolio outflows. We expect RBI to defend R65/USD if the US dollar persists at 1.38/euro.

(iii) Interest rates fall: We think that the RBI could cut rates if the fragmented coalition is driven

by a much more pro-growth Keynesian economic ideology than the anti-inflationary monetary policy stance.

(iv) Markets drop 15-20%: We believe the market is currently pricing in a stable coalition. In case of a shock result, we see a steep correction in the market as hopes of an early revival in the economy are dashed.

(v) Sector strategy in this scenario: Buy exporters and quality defensive: We would stick to exporters and quality defensives in such a scenario. Our preference would be towards exporters that benefit from a rupee depreciation including software (TCS, Tech Mahindra) and pharma names (Lupin) as well as high quality growth stocks like ITC and HDFC Bank.

Improvement in macro-economy drives market stability

While growth continues to be sluggish, we highlight three macro-economic indicators that have improved and reduced India?s vulnerability.

#1: Current account deficit has eased significantly. From a CAD of near 5% in FY13, we are forecasting a CAD of only 2% for this year. On the back of improving exports and lower gold imports India posted its best ever CAD data in 20 quarters.

#2: Inflation has eased. On the back of lower food prices WPI inflation is at close to the lowest level in the last 52 months. While near-term we could see an increase in inflation led by a spike in food prices due to poor weather conditions, over the medium term we expect inflation to be under control.

#3: Earnings revision ratio has been improving. Another positive for the markets has been the improving earnings revision ratio (ERR) over the past eight months. Though the ERR is still below 1, a stable reform-oriented government could boost it further as optimism returns back.

Capex cycle recovery post elections will be slow: The recovery of the capex cycle will be a slow and gradual process, in our view. There are some factors that will improve quickly but some hindrances will linger longer:

What will improve quickly?

#1: Low business confidence: Weak business confidence has been responsible for risk aversion among corporates. A strong government post-elections would help reverse this.

#2: Regulatory bottlenecks: The formation of the Cabinet Committee on Investments has already started the process of easing regulatory bottlenecks. The new government post-elections will accelerate project clearances, in our view. However, the state level bottlenecks will continue to be a constraint.

What will continue to be a constraint?

#1: Capacity utilisation is still low: Investment climate is strong when capacity utilisation is high and profitability levels are strong. Currently, with low capacity utilisation and increased stress in the economy many projects are not able to meet their profit projections, leading to high level of restructuring in the economy.

#2: High gearing will likely be a constraint. Gearing in corporate India is very diverse?there is one set of companies that is sitting on negative debt levels. But firms that are leading on investment spends are sitting on high levels of debt. We think a meaningful capex cycle is unlikely till we see these companies repair their balance sheets. This will likely be led by sale of assets.

In case of a sharp rally in equity markets, we may see the repair of balance sheets accelerate if these companies are able to raise equity.

?BofAML

(This write-up is part of a series of BofAML report, called ?2014 Election Countdown?, focussing on the General Elections)