Market after AAP

The stock market expressed a 500-point disappointment at the first signs of a BJP defeat in Delhi, while today they appeared to gather courage. However, the robust confidence of the January contract is missing.

There are a bunch of factors that have weighed on the market. For one, crude prices after continuously pluming to unbelievable depths for three months have bounded 10% in each of the last two weeks. Secondly, and more importantly, the third quarter earnings have been way more than one-off disappointments. In fact only a one-off result has surprised positively. Thirdly, and following from the previous two, FIIs have been net sellers for practically all of February. Although, the selling has been moderate it has been over half a billion dollars in ten days.

The bulls have not yet thrown in the towel but there are reasons to believe that their resolve would have weakened. The markets fear, resounding victory of the Aam Aadmi Party (AAP) may dent Narendra Modi's reform momentum. However, there is no way of knowing Narendra Modi's mind for sure and various factions in the BJP can react to the AAP victory in various ways. The RSS core may see more Hindutva as the answer to restore the BJP's popularity. The nationalist-socialist faction may read the AAP victory exactly as the Congress read the BJP's defeat after its "India shining" campaign in 2004. That the masses have rejected the pro- business thrust of the BJP and the government should hence revert to pro-poor policies such as more subsidies.

The market may well worry that this view could sway PM Modi, especially because the AAP is widely seen as having won on account of its promise of 50% cheaper power, free Wifi and rightful access to water. It is this set in the market that believes the pre-budget rally is over, or that if there is one, it would be the best thing to sell into.

However, I think it is unfair to believe Narendra Modi would be so naive as to change his policies, indeed his beliefs with one defeat. He has been chief minister of a state for two terms – a state which he guided to tangibly better standards in those years. He was also the brain behind a most well thought out and executed election strategy resulting in the biggest landslide victory in India in 26 years. I doubt he will buckle under one defeat. There are hardly any elections until October and even in Bihar the ruling party is making sure, the BJP won’t have to do much to win, but simply desist from anything stupid.

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Therefore, chances are that Narendra Modi will stick to what he thinks is the best prescription for growth without being distracted by the Delhi mandate.

But is that enough to cheer the markets?

Even if PM Modi concentrates on economic growth with the best of intentions, the market needs to worry that his problems have just gotten tougher. The third quarter earnings are disastrous for a whole host of sectors - metals, infrastructure, and capital goods. A series of earnings downgrades have been the order of the day. The bank earnings are revealing a malaise deeper than what the market, the government or the RBI was prepared for.

There is every danger that at the end of the results season around 6% of the sector's loan book would have turned bad. Unofficial estimates of restructured loans are at 15 lakh crore. If half of these turn bad, the total bad loans may well be close to 20% of the banking sector's loan book and that is a systemic problem. How can the banking sector lend under such circumstances especially with little additional capital coming in. Moreover, once the cash stops, things can deteriorate even faster.

In May 2014, optimists had seen the earnings inflexion point one-year down. Pessimists saw it six quarters away that is in September 2015. Today, after looking at the third quarter numbers and the banking non performing loans (NPLs), it will only be a brave man who will bet on an earnings growth by September. In May of 2014, the markets were betting on an over 10% earnings growth for this year and a 16% growth for next year.

However, this year's earnings growth has now been scaled down to 7% and on this low base, many think next year’s 16% needs to be scaled down. So, is market cheap even at 8,300? That should be the question that should worry the market more than the impact of AAP on the Budget. The bigger worry - Are the economy's problems too intractable to be answered in one Budget or even in one year.