>The Push and Pull of Earnings vs. Inflation vs. Risk Appetite (MORGAN STANLEY)

■ Key Debate:The market is currently grappling with three key developments –strong growth, policy exit (relating to prospects of higher inflation) and global uncertainty or declining risk appetite. Global risk appetite will determine the absolute multiple for the market, whereas the inflation outcome will determine India’s relative multiple. How will the market respond to the interplay of these factors?

■ Growth Accelerating Faster Than Expected:The earnings environment is very strong. We see upside risks toour earnings forecast, which is in any case ahead of the consensus. We are expecting BSE Sensex earnings growth to compound at 18% annually to F2012 versus the current consensus estimate of 14%. Both top-line growth and margin improvement are supported by the macro environment and are driving earnings higher. As in the previous cycle, the broad market earnings growth will likely beat that of the narrow market. Indeed, broad market earnings (ex-energy) are almost at the previous cycle peak (note that the small and mid-cap indices are still 42% and 37% off peak, respectively). The key risk to earnings, in our view, is that weak global risk appetite causes capital flows into India to slow down, thus negatively affectinggrowth.

■ Policy Exit –To Do or Not to Do:While strong earnings growth should augur well for the market, the market is currently grappling with two headwinds. The first headwind is home grown and relates to the risk of rising core inflation (and hence higher short rates). History suggests (and we go back to 1997, 2000 and 2004) that the market multiple tends to decline when short rates inflect in the upward direction. While in 1997 and 2000 the rate rise happened in a slowing growth environment, causing significant damage to market multiples, the 2004 rate change took place in an accelerating growth environment, and the fall in market P/E proved temporary. We believe that the current environment resembles 2004, with a rise in short rates likely to pre-empt inflation pressures in an accelerating growth environment. Indeed, the policy environment remains close to emergency levels even though the economy does not appear to be anywhere close to a crisis. The key risk is that the central bankfalls behind the curve and rising inflation ultimately hurts growth and stock prices in 2011. We believe that the central bank will react to incoming data, especially on credit growth, and tighten accordingly. Of course, the challengefor the central bank is to estimate the impact of stimulus on growth (how much of the current growth acceleration is autonomous), the next monsoons and global growth (which, in turn, may depend on behavior of risk assets).

■ Global Risk Appetite –A Tricky Phase:The second headwind is a reduction in global risk appetite relating to growth, monetary policy exit and sovereign contagion. Global risk appetite continues to be important (Indian equities are still highly correlated to the rest of the world), as India depends on capital flows from financial markets to fund its balance sheet. A sharp and protracted reduction in risk appetite would affect India’s growth rate and, ultimately, share prices.

■ End game:The good news is that the market is already aware of most of the risks but needs time to settle the debate. The near term is likely to continue to be volatile, but we think investors should be buyingthe dip rather than selling the rally. 2004 is a good example of how “dip buying”paid off handsomely. Our scenario analysis on the BSE Sensex suggests a base case upside of around 20% in 2010, which probably compensates investors for the risks they may be taking in the near term.

To read the full report: INDIA STRATEGY