Last week saw both the Sensex and the Nifty scale lifetime peaks. The fact that this was a secular broad-based rally was reflected in the increase in the CNX Midcap Index — which tracks stocks of companies not so widely traded — as well as of stocks in beaten down sectors such as infrastructure. With foreign institutional investors (FII) making net purchases of nearly $2.2 billion over the week, the rupee fell below 61-to-the-dollar levels for the first time in seven months.

The optimism this reflects is a result of a convergence of factors the markets perceive as favourable. India is no stranger to pre-election stock rallies, fuelled by hope of stable governments and altered policies; this time, the BJP’s chances of coming to power under Narendra Modi, who the markets seem to adore, has strengthened somewhat with the cobbling of strategic alliances by it. Perhaps even more than this, FII appetite appears to have been stoked by ‘macro’ considerations, especially with the current account deficit (CAD) posting a sharp decline to $31 billion during April-December. A lower CAD, along with the Centre’s improved finances as revealed in the Interim Budget, has made the ‘twin deficit’ problem look less worrying than even six months ago. Overall, there is a growing perception of India’s macro-fundamentals today being better than most emerging market economies. The latest HSBC Purchasing Managers’ Index recording the highest manufacturing activity expansion in over a year, the decision to defer premium payments for stressed highway projects, the grant of higher tariffs to restore viability of imported coal-based power plants, and the likelihood of a new government giving a further boost to reforms have also contributed to the current positive market sentiment.

While there is a basis to this optimism, there is also room for caution. It is by no means certain that the election will throw up a decisive verdict. The challenges posed by the external environment, highlighted by the crisis in Ukraine, are far from over. The looming threat from El Nino-induced weather aberrations raises fears of a fresh spike in global oil and agri-commodity prices, just when inflationary pressures are easing. Then, there are the fundamentals themselves. Indian stocks are already trading at more than 18 times their underlying earnings, and also at a significant premium over benchmark emerging market indices. Sustaining these valuations would require a real turnaround in growth and investments. We are not yet seeing investments on the ground. Getting this to happen, without losing the focus on macroeconomic stability, will be the single largest challenge for the next government.

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