>INDIA STRATEGY (MORGAN STANLEY)

THE KNOWN UNKNOWNS

• The global rally in stocks has seemingly stalled, and the euphoria of the election results seems to be in share prices. Several investors are arguing for a correction. The high volatility in share prices suggests that market participants are unsure of the market’s direction. We identify the following key drivers for the market in the coming months:

• Politics and Capital Flows: The change in our view in the middle of May following the elections was not a move away from our fundamental framework. Indeed, in the run up to the elections, we had argued that if a single party won in excess of 180 seats, Indian equities would likely beat emerging markets by more than 25% in the ensuing 12 months (see note dated 6 March 2009, entitled Dealing with Uncertainty - Part 1: The Forthcoming General Elections). This forecast was premised on our fundamental framework that India’s growth was being driven primarily by capital flows and strong election results would revive capital flows. However, our base case called for a fragmented verdict. We were wrong about our assumption on the election results and, hence, changed our view on both the economy as well as the market post the elections. In hindsight, we realize that we missed the growing maturity that the electorate had been displaying over the preceding 18 months in choosing its representatives for the country’s law-making bodies and that the general election results were only a continuation of this trend.

• Budget on July 6: History does not favor a move up in the market in the month post the budget. However, we have to make an assumption ahead of the budget as we did with the election result. Therefore, we expect the finance minister to deliver a solid reform-oriented budget that will incorporate tax cuts, fiscal consolidation, a divestment program, and infrastructure spending as well as announcements relating FDI and deregulation in the financial sector.

• Reforms and the upside to growth forecasts: We raised our growth forecast following the election as we expect capital flows to improve. Since then, we think the government has struck all the right chords on reforms, and this encourages us to further raise our earnings growth forecast. The recent quarterly earnings, which have been ahead of expectations, also influences this change. We now think that earnings growth for the Sensex will be 5% and 17.5% in F2010 and F2011, respectively, in our base case. If the government executes on reforms, we believe there will be more upside to growth, especially in F2011. A notable concern would be that the social agenda takes over the economic agenda, hurting confidence and growth. Another is whether the government’s lack of majority in the Rajya Sabha hampers law making. A key point to note here is that our current growth forecast does not take us back to trend or anywhere close to the heady growth rates of the past five years.

To see full report: INDIA STRATEGY