What is in store for equity markets in '18?

2018 will mark the fourth year of the Modi government in office and the penultimate year before the general elections scheduled for April-May 2019.

With the December 2017 state election victories for the BJP/NDA in Gujarat
and Himachal Pradesh, markets may heave a sigh of relief. However, the question remains: Will the government stick to the path of economic reforms, or focus on populism before 2019?

It would be safe to bet on reforms, and we base this on a number of factors including potential of easier implementation of reforms since 19 out of 29 states in India are now under BJP/NDA rule. Several reforms including improvements to the Direct Tax Code, e-way bill, real estate sector, and banking sector, among others are on the anvil.

The reforms agenda has also been recognised globally - India has jumped 30 spots in the World Bank's Ease of Doing Business ranking. Stellar foreign inflows this year, both FDI (+US$ 54.7 billion till October-end) and FPI (+US$ 8.5 billion till November-end), on the back of reforms are another factor.

The government reforms over the past couple of years could broadly be broken into three main categories:

n Crackdown on black money

n Financial inclusion through Aadhaar and Jan Dhan bank accounts, and

n Direct Benefit Transfer (DBT) of subsidies. These are critical long-term structural reforms, the benefits of which will be realised over the next few years, albeit causing near-term pain to growth and earnings.

However, this did not stop Indian equities from rallying sharply in 2017 - up 36% in USD terms or 28% in INR terms. The obvious question has been on high valuations and its sustainability. This run-up has been a part of the broader EM rally and India is not an outlier. Markets are certainly at a high, but valuations are not. An earnings catch-up could certainly help sustain these valuations. Corporate earnings are expected to see a broad-based recovery in FY19 and FY20. Along with the positive base effect, a mix of global cyclicals (metals), autos, oil marketing companies and banks may be the key drivers for this.

After hitting a low of 5.7% in Q1 FY18, GDP growth recovered to 6.3% in Q2 FY18, and the upward trend is expected to continue. With demonetisation behind us, implementation of the 7th Pay Commission along with the higher government spending on the rural segment could help support demand. This should benefit consumer facing companies like staples, consumer durables and other under-penetrated sub-sectors, which will also benefit from initiatives on "Housing for All" and "Power for All".

On the flows front, domestic flows, led by mutual funds, are expected to continue to outpace foreign flows for the fourth year in a row in 2018, as India is finally witnessing a shift from physical to financial savings which looks more structural.

Emerging Markets (EMs) have seen equity inflows of ~70 billion in 2017 so far, which is after four years of net outflows from EMs.

Global portfolio managers are underweight EM equities, leaving more room for additional buying in EMs and India.

The INR continues to remain one of the best performing currencies since the Taper Tantrum in 2013 and has also been amongst the least volatile. This trend is expected to continue over the next few years with RBI committed to keeping the currency stable, and with the improvement in forex reserves and FDI.

While the broad outlook for India may remain positive, there are certain risks which investors must consider. These include a shortfall in the yearly GST collection, which could negatively impact fiscal deficit, rising oil prices
which could lead to higher current account deficit, rising inflation (higher oil and food price base effect), and geo-politics (China's growing influence and strength in the region).

There are four key themes that could drive growth in 2018 and beyond:

n Increase in per-capita GDP boosting the India consumption story – and a consequent shift from unorganised to organised sectors.

n Penetration of financial services (retail and corporate credit, insurance, asset managers).

n The next investment cycle led by government capex on Oil & Gas, Defence, Roads, Railways, and Urban Infra.

n Export opportunities in segments vacated by China, such as textiles and speciality chemicals.

2017 has been a very healthy year for equity markets across the board. Going into 2018, market returns are more likely to be linked to earnings growth, given that valuations are already above average.

As seen over the last year, bottom-up stock picking has created considerable alpha, and investors therefore may need to identify the right combination of stocks and sectors that can outperform the broader market.

(The writer is Chief Investment Officer and Head of Equities at DSP BlackRock Mutual Fund)