>INDIAN EQUITY STRATEGY: Staying Bullish, Sensex Target of 22,680

Positive stance continues - Expect markets to be volatile on global cues - recommend BUY on corrections

8.2% GDP growth est. for FY10-11 build in ~5.4% inflation expectation

Credit growth: Systemic credit growth upped 19%, riding on 3G and BWA auction, and is likely to stay strong YoY. Expect 22% credit growth for FY11.

Interest rates: Systemic interest rates likely to rise with next regulatory push. We expect policy rates to rise 75bps with lending rates lagging deposit rates.

Fiscal deficit: Expect consolidation at ~5% of GDP: We believe the government’s attitude towards fiscal discipline and the excess cash flows available warrant a sharp reduction in its borrowing programme.

Strong corporate earnings growth: Our Sensex EPS for FY11E is Rs1,053 and for FY12E, Rs1,260. We note the index is trading at 17x FY11EPS. Our EPS estimates are ahead of consensus by1.8% and 1.2% for FY11E and FY12E.

Volatility measures: Indian IVs:US VIX has been on a decline through the Euro market crisis — points to relatively lower risk aversion for Indian equities. MSCI India index has outperformed MSCI ACWI index on a 12-month relative basis while MSCI EM has underperformed.

Sensex trading band: Sensex valuations
(1) Sensex dividend discount model: Indicates the range 16,360-21,189. We believe the 7.5-8.0% 10-year bond yield could mark peaking of current interest rate cycle; (2) P/BV: Positive divergence in the premium.

Currently the Sensex is trading at 2.8x P/BV FY11, 17% disc. to its LT average P/BV of 3.4x. When it reverts to the mean, an index level of 21,250 is implied; (3) PE basis: On our FY12E earnings of Rs1,260, we expect the index to trade between 17,640-22,680. On projecting the Sensex on earnings yield and current 10-yr bond yield, we do not expect the market to go below 16,100 in
FY10, except on a global sell-off.

Our model portfolio plays out India’s domestic consumption story: Domestic consumption is strong and resilient but rate sensitive. We expect domestic consumption to pan out more rapidly and domestic sectors/stocks that reflect this will witness expansion in valuation premium v/s the markets.

Large cap companies with low leverage will continue to command similar premium valuations. We recommend — focus on large caps and larger niche mid-caps: We are OVERWEIGHT Industrials, Consumer Discretionary, Consumer Staples, Financials (upgraded from Neutral), Healthcare and Software and UNDERWEIGHT Energy, Materials, Telecom and Utilities.

Risks to equity markets: Market risk = the widening deficit in global economies and escalating credit concerns that suggest risks to sovereign defaults. Global aversion would impact mid-cap stocks the most, and they have been the stellar performers. Commodity prices are also at risk given fallout in the European Union and we expect metal prices to be volatile. We do not expect substantial earnings downgrades such as in 2008, as the domestic Indian economy is fairly resilient.

To read the full report: EQUITY STRATEGY