>Buy the Macro, Hold the Micro, and It’s Not Expensive (CITI)

■ India should go up — We get more constructive as: a) Domestic Macro headwinds could well have peaked; worst on inflation, rates and the fiscal deficit possibly over; b) Micro momentum and corporate rationality still in place; rising FCFs, higher ROEs, and reasonable earnings growth (albeit some slackening); and c) India is no longer expensive – trading below its long-term averages. India’s rising dependence on global capital flows, and global volatility, will raise market beta; but looking through we raise our Sensex target index to 18,100 (15X 1yr Fwd PE – long term average), and shift to a more aggressive model portfolio.

■ Buy the Macro — The deteriorating macro has been a significant headwind for the Indian market/economy; we see a possible turn with: a) Inflation showing signs of peaking b) rate rise trajectory easing domestically and globally, and c) fiscal strains easing with oil prices and 3G auctions. It’s not a tailwind yet; rates will still rise and global capital flows could be disruptive (equities, currency and liquidity), but the macro’s direction could well be turning.

■ Hold the Micro — The corporate sector is sustaining a sweet spot: a) Earnings should rise 24%+ in FY11 (15% over FY11-12) b) ROEs should bounce to 19% in FY12 c) Business should generate cash flows – FCF yields at 3%+ in FY12 d) Sales momentum is high (15%) and sustaining. While earnings revisions momentum is slackening, and earnings vulnerable to lower commodity prices, India’s corporates in decent shape – growth, balance-sheet and confidence wise

■ It’s not expensive — India is trading below its long-term PE and PBV averages; is no longer expensive in absolute terms, and returns are looking up too. We see the environment supporting average multiples, which suggests 8-10% upside from here. Macro needs to fully align with the micro for premium valuations (or reverse for discounts); don’t see either yet. More aggressive portfolio with OW’s on financials, Capital Goods, Energy and Auto; UW’s on IT, Utilities and Materials.

To read the full report: EQUITY STRATEGY