Bears worry about rates, the BoP, a government-RBI rift, tepid growth, impending elections and tighter liquidity. Our counter is that credit growth is at a five-year high, inflation is benign, the policy response to the liquidity crunch has been significant, oil prices are well off highs, aggregate earnings are in-line, domestic flows look solid, valuations look increasingly supportive though not universally in a buy zone, and sentiment indicators are in buy zone. India has regained about a quarter of its September underperformance since its bottom relative to emerging markets on October 9.
Rates: Domestic liquidity has been enhanced by policy makers and headline inflation is benign, implying a softer rate environment in the weeks ahead even as the rift between the government and RBI represents a risk to shares. Tighter liquidity for non-bank finance companies is an opportunity for large banks to gain share, evident in the way bank credit growth posted a five-year high at the end of October. Liquidity pumped into the system will likely find its way either into the real economy or into the asset markets.

Politics: History suggests that share price volatility is likely to rise in the months ahead of elections. We opine that investors should watch growth, pre-poll alliances and key indicators across inflation, farmer sentiment, direct benefit transfers, and jobs to judge how India’s state and general elections may pan out.

Earnings: For the past two years, we have been forecasting a turn in earnings which hasn’t happened, creating deep skepticism whether the 8-year-long earnings recession is over. While we have trimmed our FY2019 and FY2020 Sensex EPS by 1% to reflect 2QFY2019 results, revenue growth is a sign that we are headed for a strong second half, led by corporate banks.
Demand-supply: Foreign portfolio selling has reset ownership in India versus emerging markets to seven-year lows, creating room for buying by foreign investors. Domestic households continue to make a strategic and structural shift toward equities.

Valuations: PE, relative valuations and valuations vs. rates are still not at buy levels. In our view PB is a better timing tool given the earnings and rates cycles. The PB has broken its 2013-2018 range to the downside and is at levels offering better than fair equity risk premium.
Sentiment: Most of our sentiment signals including our proprietary sentiment indicator, market breadth and inter day volatility, are at buy levels.
Portfolio strategy: We like GARP (growth at a reasonable price) stocks among banks, discretionary consumption and industrials—both large and mid-caps.

Edited extracts from Morgan Stanley report on India equity strategy