Just when it was given up for dead, the market has bounced back sharply on hopes of big ticket reforms and a decline in international oil prices. Is the market hoping for too much on the reforms front and will this relief rally last? By Vivek Sharma

Barely a couple of weeks back, stories in the financial press were all about the weak market sentiment. Most of them talked about record oil prices, rising inflation and interest rates, declining corporate profitability, political uncertainties and renewed fears about the global credit crisis. Major domestic indices had crashed more than 40 per cent from the peaks scaled earlier this year.

The mood started changing towards the end of last week. Globally, oil prices corrected and major American banks posted results that bettered expectations and brought down fears of the credit crisis worsening. Domestic political uncertainties seemed to be easing as the chances of the government winning the confidence vote, which it did this week, increased.

The revival in sentiment was so strong that short positions were squeezed and the Sensex surged more than 17 per cent in just five sessions.

Just as the Sensex recovered, all the talk now is about the coming reforms blitzkrieg. Markets now expect major reforms in insurance, banking and power sectors. FDI limits in the first two are expected to go up while the mega power projects may get a push to ensure speedier implementation. Banking stocks, which were beaten down the most last month, led the rally and accounted for a big part of the index gains.

Among the Ambani brothers, political climate is now deemed to have turned in younger brother Anil's favour and all the ADAG stocks have made smart gains.

How significant are the political developments and the decline in oil prices? Is the market hoping too much on the reforms front and will this relief rally turn out to be yet another dead-cat bounce, like the one we saw in May this year?

Oil prices have to fall a lot more to make a difference
It is true that international crude oil prices have corrected from over $145 per barrel earlier this month to settle below $125 yesterday. It is possible that international oil prices will remain at these levels, or correct some more, unless there is a flare up in the stand-off with Iran. The decline by over $20 per barrel will be significant for the prospects of many economies, and global markets have reacted positively over the last week.

However, the gains to Indian economy are not as real. The gains will be real only if retail fuel prices come down and lower inflationary pressures. That is unlikely in India anytime soon because local fuel retailers will still make losses even if international crude prices slip below even $100 per barrel. Else, the government should take a conscious political decision to inflict more pain on the oil retailers by cutting fuel prices.

The only gain from India's perspective is that the fear of another fuel price hike adding to the inflationary fire has subsided. While that is a positive development, it will have a favourable impact only on sentiment and not on real economic data.

Can the government really fast-track reforms?
The biggest bet in the market over the last week is that the government will finally get to do some big ticket reforms. As some commentators said, the "left monkey" is off the government's back and the prime minister will have much more freedom to dust up the reforms agenda. Much of the analysis and comments in the financial media after the trust vote stressed on the major policy initiatives that are on the anvil.

The government's new partner, Samajwadi Party, is seen as more flexible even though its publicly stated policies are hardly different from that of the UPA goveernment's former allies, the Left parties. The last election manifesto of the Samajwadi Party had even calls for a ban on import of luxury goods.

The Samajwadi Party has already stated that it will support reforms in financial services and banking. The expected reform initiatives in these sectors include higher FDI limits in insurance, pension system reforms including opening up pension fund management to private fund managers and removing the voting restrictions in the banking sector for foreign investors.

Banking and financial services stocks have soared over the last five days, some have surged well over 20 per cent in this period.

Will the government go ahead with these anticipated reforms or will it prefer a politically safer route and focus more in inflation management and more populist initiatives? Despite the trust vote win, the Congress Party has seen its political fortunes on the decent in recent months after the loss of many state elections.

To arrest the decline, the easiest option for political parties in power is to turn more populist. It is easy to talk about reforms, but political compulsions will undoubtedly take precedence in an election year. Interestingly, neither the prime minister nor the finance minister uttered a word about reforms during the trust motion debate.

Even if the government gets serious about these reforms, the RBI has a bigger say on the most important item on the agenda. For easing voting rights restrictions in the banking sector, the RBI already has a route map which has set 2009 as the year for the final opening up. Will the government go as far as pressurising the RBI to advance that date? Unlikely. The decision is more likely to be taken by the next government, the shape and orientation of which we can only speculate now.

Outlook can get gloomier
The biggest risk is that inflation can get even worse and force RBI to continue hiking interest rates. How bad can that be? The most pessimistic forecast yet is from Barclays, which expects annual inflation to top 17 per cent and the repo rate at 10.5 per cent or more by the end of this year. Yes, those forecasts appear a bit too pessimistic at this point. But the risks of inflation and higher interest rates remain real.

To make it worse, the fiscal deficit has reached alarming proportions. And it can get even worse when the latest pay commission recommendations are implemented, as the government is expected to do before next year's general elections. It is also likely that more populist programmes will be announced over the next year, as governments often do ahead of elections, and will further strain public finances.

The global economic outlook is also not that rosy. The most recent quarterly GDP growth numbers from China shows a decline while the Asian Development Bank and the IMF expects inflationary pressures to rise and growth rates to soften across East Asia. Growth prospects will remain weak across Europe as the ECB will have little leeway in bringing down interest rates on inflation which is well above its policy target.

While the US economy is yet to slip into a recession, most recent forecasts have turned very pessimistic because of an expected decline in consumer spending. Merrill Lynch now expects the American economy to actually contract by 2.5 per cent in the last quarter of the year, and by a similar rate during the subsequent quarter too.

Overall, the investment bank expects the US economy to contract this year and says the recovery will not start until the last quarter of next year. If these forecasts turn out to be accurate, global markets will continue to face rough weather.

Corporate earnings growth may weaken further
Corporate earnings growth for the most recent quarter was the weakest in many years. Margins have eroded mostly on higher input costs and companies find it difficult to pass on the costs to consumers as pricing power is steadily eroding. In some cases, like steel and cement, government imposed price controls have been the culprit.

The real slowdown in corporate earnings may be yet to come. Domestic consumption growth has not yet dropped appreciably, but the effects of higher inflation and interest rates will soon show up. Income growth will be subdued as salary growth across sectors has been lower this year, and possibly for another couple of years.

Sales of durables have turned weak and there are no takes for space in new malls coming up. 

Yes, the market appears far cheaper after the correction over the last six months. However, valuations look attractive only because earnings growth estimates remain high.

When the estimates are revised lower, which is very likely given the emerging scenario detailed earlier, and the euphoric hopes over reforms meets the reality of coalition politics, the market may still look expensive in the short to medium term.

For very long-term investors, with an investment horizon of five years and above, the market will throw up very attractive opportunities over the next year or two.