HONG KONG: Exactly a year ago, going into 2006, UBS’ chief Asia economist Jonathan Anderson recalls that the overriding fears for the Indian economy were the potential for a hard landing in the financial markets, and a “potential equity bubble”.

And although the feared massive selloff came on Dalal Street in mid-2006, mirroring similar sharp falls in global stock indices on fears of higher US interest rates, the benchmark Bombay Stock Exchange Sensex ended the year nearly 50% up from the start! A phenomenal year, by any standard, and foreign institutional investors (FIIs), who invested a net $7.9 billion in Indian equities in 2006, made money hand over fist.

And now, at the start of 2007, the outlook for India “no longer looks as risk-fraught as it did in early 2006,” says Anderson. “We still expect more policy tightening and an economic slowdown ahead.

But, for the time being at least, financial markets are better supported than they were a year ago.”

Yet, ironically, although FIIs by and large maintain a positive outlook on the Indian market, returns on equity investments in 2007 aren’t, in their estimation, likely to be anywhere near last year’s high. The best-case estimates for the Sensex by end-2007 vary between 15,000 and 16,000. That represents returns of between 7% and 15% from here on.

CLSA equity strategist Christopher Wood reiterates his faith in the Indian market when he says that “investors should remain long in the world’s best growth story” and every time there is a market correction, treat them as “buying opportunities.” Wood notes that “it takes a visit to India” to renew confidence in the investment story: “This is why investors who have never bothered to visit the place have missed out so badly in recent years.”

There is, for instance, “growing evidence of the commencement of the mother of all capital-spending cycles.”  And there is “growing evidence that the infrastructure build is finally happening… It may not be happening as quickly as some would like, but it is happening.”

Anderson notes that from early 2004 through to early 2006, the Indian equity market not only more than doubled in domestic currency terms, it also rose substantially relative to the rest of Asia. By contrast, over the past 12 months, he says, the Indian market has stabilised against its neighbours - “and has actually become less overvalued vis-à-vis the Asian average.” The Indian market “still shows up as overvalued” by about 20% or so against the rest of the region, he adds, but the extent of overvaluation is falling over time.

“Things look somewhat better in the domestic financial markets as well,” notes Anderson. Both foreign and domestic players were exiting the bond market towards the end of 2005, and the only real source of new portfolio money was coming from foreign equity investment. But now, “investors have returned to the bond markets, and the investment outlook is no longer running on just one piston.”

UBS’ director of investment research Manishi Raychaudhuri has set an end-2007 Sensex target of 15,000. (In end-2005, he had set an end-2006 Sensex target of 8,700, which the market’s spectacular performance last year proved to be overly conservative.) Raychauduri says the Indian market “is fully valued now, with little possibility of a further rerating” over the next year. Returns from the Indian market in 2007 “are likely to be moderate.”

In his estimation, the key drivers of the market are likely to be a combination of stable economic growth and corporate earnings growth, acceleration in the capacity expansion and investment cycle, and a stronger rupee (which will keep fund flows stable). Among the perceived risks, he says, are the possibility of the Reserve Bank tightening further and the possibility of a slowdown in inflows into emerging markets (and into India).

JP Morgan Chase Bank’s vice-president and senior economist Rajeev Malik says the the outlook for corporate earnings growth in 2007 remains healthy as key growth drivers, including the investment cycle, increased outsourcing and a stable consumption cycle, remain. “However, growth rates could moderate, given a more challenging base effect and tightening in local liquidity.”

“Market expectations of 34% earnings growth for FY07 appear stretched… This raises the possibility of earnings downgrades,” cautions Malik.

Citigroup’s head of India research Ratnesh Kumar says in a recent research report that “after four years of spectacular performance”, he expects 2007 to be a “steady year due to valuation hurdles”. He has set a Sensex target of 14,700-16,000 by December, 2007, which is a 10-20% premium to fundamental fair values based on Citigroup’s valuation models.

Others, however, take a rather more dim view of the Indian equity market’s outlook for 2007. Credit Suisse, for instance, is underweight on India, citing “a high likelihood of a valuation derating and poor medium-term returns.” Pointing to the possibility of an erosion in the return on equity and “earnings misses”, it says these “could cause investors to question the level of valuation being paid.” On the macro side, “we see higher interest rates as likely, and higher investment could result in a widening current account deficit despite the benefit of lower oil prices. If this were to occur, there is a danger that the currency will weaken and foreign capital will leave the markets.”