>TUG OF WAR (HSBC)

■ Lead indicators point to strong pick-up in growth. Economic data is likely to surprise on the upside, yet expectations of corporate earnings remain muted. Analysts are forecasting 2% growth for FY09-10e and have yet to upgrade meaningfully.

■ Growth surprises are likely to drive EPS upgrades over the next 2-3 quarters. The Sensex is trading at 12-month forward PE of 17x, indicating limited room for multiple expansion, but we think upgrades will provide support. Our top-down Sensex EPS forecasts at INR920 for FY09-10 and INR1120 for FY10-11 are c6% higher than consensus.

⇒ Markets to move higher in the next 12 months as growth surprises on upside, leading to EPS forecast upgrades

⇒ Policy tightening may cause markets to stall, but underlying supportive environment will remain intact

⇒ We maintain a pro-cyclical view; overweight on banks, industrials, IT and consumer staples

■ Our economists expect RBI to tighten monetary policy with 200bps of CRR and 125bps of policy rate rises in CY2010. Since monetary policy works with a 12-24 month lag, this is unlikely to restrict growth in FY10-11. Tightening will be the result of a pick-up in growth, so this will be not be a disaster for equities; however, evidence suggests the first move in a tightening cycle causes markets to pause. We think the equity markets will be torn between rising growth expectations and rising rates, which will play out simultaneously over the next 2-3 quarters.

■ We think the markets will move higher – but with the dampener of the rate rise, only just: end-2010 Sensex target 18,000, Nifty 50 target 5,350, both up 7%. Also, we expect that gains in Indian equities may lag other markets; hence, we are underweight on India in our Asia portfolio.

■ Our investment strategy remains pro-cyclical. Our overweight sectors are private sector banks, industrials, consumer staples and IT, and our key underweight sectors are materials and healthcare. Our top picks are HDFC Bank, Hero Honda, BHEL, ITC and TCS.

To read the full report: INDIA INSIGHTS