India’s biggest problem – the inability to produce enough to satisfy domestic demand – has led to structurally high inflation and high current account deficit (CAD).

We calculate that India’s growth-inflation trade-off is almost as high as the levels seen in the post Asian crisis period. Coupled with rising household inflation expectation, this could constrain the RBI to cut rates only by 50bp by FY13-end.

A consequence of sticky inflation and potential decline in government’s consumption-supportive measures could be potential moderation in consumption growth. The latest risk to consumption comes from a potential monsoon failure. Our analysis shows that in the four years (among past 12) when monsoon failed, autos and consumer staples (particularly auto) stocks underperformed both in the short and medium term.

The silver lining is that lower commodity prices mean CAD is peaking out. Sharply lower commodity prices (crude oil, coal, metals) are having little impact on domestic inflation or subsidies due to the INR depreciation, but are reducing CAD. Anecdotally, India’s gold imports are also down 25-30% y-y in FY13 so far. We estimate CAD at 2.8-3% of GDP in FY13, compared to 4.2% in FY12.

Baby steps towards policy reform have begun. Small steps to improve fuel availability for power, postponement of controversial tax laws, and more investment-friendly policies for airport and road sectors are visible. Politics is the key to watch near term.

FII inflows have not dried up and there is large cash with domestic institutional investors (DIIs). Despite the negative sentiment and bad press about policy paralysis, Indian equities are the second best performer among EM in local currency this year so far. In US dollar terms, India has done better than all large emerging markets – China, Brazil, Korea, MSCI EM and MSCI AxJ. Despite being verbally bearish on India, FIIs have ytd invested USD8.6b in India – 56% of FII inflows into Asia-6. DIIs collectively are sitting on USD10b-11b cash (10% of AUM), which could provide support to the market if FIIs turn aggressive sellers.

Our Sensex target – using the P/BV parameter – at the beginning of the year was 18,500. We retain the target as none of the major parameters – interest rates or cost of equity – have changed dramatically. Our bottom-up Sensex target (18400) is similar. At our target, Sensex would trade at 13.4x 1-year forward EPS.

We are overweight on auto, pharma, utilities, E&C; and underweight on banks, metals, consumers; Neutral IT, telecom and energy.

We advise investors to play the consumption theme through discretionaries, policy stabilization theme through select industrials and the INR weakness theme through IT and pharma. On financials, we remain concerned about potential non-performing loan increases for PSU banks.