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The Modi Rally In India

The Indian Nifty Index is up 27.7% from its August 27th 2013 low and is continually hitting all-time highs. The country experienced a current account and currency mini-crisis and the economy was left for dead during the second half of last year. However the stock market remained resilient and has powered ahead to unchartered territory in 2014.

Amidst investor criticism, the Indian government was able to bring in a new Reserve Bank of India (RBI) governor, Raghuram Rajan, who acted as a savior and steadied the ship. India had been suffering from stagflationary pressures where Real GDP slowed down from over 9% in FY2011 to 4.4% in FY2013 whilst Wholesale Price Index (WPI) remained rigidly above 7%. Rajan took a hawkish stance and increased the repo and reverse repo rate by 75bps from 7.25% & 6.25% to 8% & 7% respectively over three RBI meetings. Rajan then tackled the current account deficit by introducing two short-term policy fixes where the RBI engaged in (i) a FX swap window which raised USD 34B of Non-Resident Indian deposits and (ii) quantitative control of gold imports which aimed at helping reduce gold imports by USD 30B over a 12 month period. The current account deficit is now less than 1% of GDP after peaking at approximately 6% of GDP and the last WPI print came in at 4.68%. Real Deposit rates are now positive, the currency and current account have stabilized and this therefore has ignited a 'Rajan' rally.

Rajan brought the Indian economy into stabilization, but in order for India to reach potential GDP of 8%+ India needs a stable government with a leader that can push through structural reform and execute on the infrastructure projects which India so desperately needs. This is why the coming general elections are so important. The markets and polls suggest that a new government coalition led by the BJP should come to power. BJP's charismatic and go-getting leader Nirendra Modi is expected to assume power as the prime minister. Given his stellar economic track record in Gujarat (10% annual GDP growth rate from 2004-2012) where he served as Chief Minister for 13 years markets are excited at the prospects for the country. On arrival into office he is expected to identify the 25-50 most important stalled infrastructure projects, locate bottlenecks and authorize their removal. In addition the BJP party has vowed to create 10 million jobs. The election will be held in seven phases from April 6th to May 12th 2014. The first exit poll will come on the evening of May 12th, and the counting will occur on May 16th.

The Nifty trades at 12.1x FY2015 P/E according to a Bloomberg Survey of Estimates. Over the last five years, the forward P/E band has ranged from 11x to 16.8x and this measure reached as high as 19.5x in 2007. For the Indian markets to keep on its ascent, a decisive election result is necessary. However it must be followed up with a slew of reforms to wind down subsidies, lift capital productivity and deleverage the SOE banking sector. Markets are confident that Modi will deliver on these reforms, and if this is the case a cyclical uplift and a significant rise in potential output could be on the cards over the next five years. This could cause a significant rerating of Indian markets as the Nifty has valuation support compared to recent history. On the other hand, an indecisive election result may put Indian politics back to a 1990's-like impasse where governments kept breaking up. This will probably put an arrest to the current Nifty outperformance.

An electorate of 800 million people however is impossible to predict - volatility is a certainty.