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We expect the markets to pause for breath after a frenetic ~10% Nifty rally since the tariff pause announcement on 9-Apr-25. Valuation comfort has largely eroded and escalation of the Middle-East conflict could trigger a sell-off. From a medium-term perspective, though, we are not worried. The crude price spike is likely to be transient and India’s fundamentals are otherwise looking up. We see an earnings recovery on the back of aggressive RBI easing and weak commodity prices. Our sector preferences are unchanged and we are positive on Discretionary, Technology, and Materials, and UW on Financials and Staples. Our weekly product returns in a new avatar – a changed title and a new cycle of weekend publication.

Middle-East conflict: short-term risk

The Israel-Iran conflict adds a worrying new dimension to the Middle-East conflict, and represents a short-term risk to markets. The biggest pain point for India is the spike in crude oil prices which would hurt the CAD, fiscal, and inflation. We believe this impact is transitory as the fundamentals for crude prices remain weak due to energy transition and slowing growth in western economies. Foreign flows may also be affected, though that too would be short term. Our fundamental thesis on Indian markets is unchanged as of now, and we will revisit it if crude prices remail elevated for 2-3M. Sectors that are vulnerable to a sustained crude spike (not our base case): oil marketing companies, autos, and staples. Selectively, some pharma API manufacturers and chemical companies could also see RM pressures.

Earnings bottoming out

Earnings have held up through the latter half of the earnings season. The FY26 Nifty EPS (Bloomberg consensus) fell 3% in 1QFY26, and Emkay estimates have been stable at Rs1,128. The breadth also improved and the share of stocks (from a 504-stock universe of 5+ analyst coverage) with over 10% EPS cuts fell, from 49% in 4QFY25 to 22% in 1QFY25. We believe that we are at the bottom of the earnings downgrade cycle and see a possibility of upgrades. The positive impact of the RBI easing and margin benefits from weak commodity prices are not captured in the FY26 forecasts. We maintain our FY26/FY27 Nifty EPS forecast of 1,128/1,294, respectively.

Valuations

The 10% Nifty rally from the bottom, on 9-Apr-25, has plucked out valuation comfort from the market. The Nifty is trading at 20.9x 1YF PER – just below the LTA, although SMID indices are trading above their 5Y LTA. Worryingly, 38% of the BSE200 stocks are trading above the 5Y LTA vs 12% on 9-Apr-25, showing some valuation froth in the broader universe. We are convinced that SMID PER premiums to large-caps are supported by superior composition, higher growth, and improving balance sheet metrics, though investors should nevertheless be selective when valuations cross the 5Y LTA. From a 1- 2Y perspective, we see SMIDs offering better opportunities than large caps, partly because we are negative on Financials and Staples, which have a heavy weightage in the large-cap universe.

Fund flows

Fund flows have remained strong. Domestic flows into MFs have accelerated through May after the market bounced in April and global risks receded. FPI selling started to ease from March and turned positive in May. The resurgence of geopolitical risk could see a renewed spell of FPI selling, though we remain constructive over the medium term. As the US economy slows, we expect elevated emerging market flows and India should stand out due to the cyclical recovery in the economy in 2HFY26. The elevated valuations also pose a near-term risk to FPI flows. We have seen no worrying signs from a supply perspective, IPOs and QIPs have remained muted (Rs110bn in the last 1M) albeit are showing early signs of a pick-up. There has been a sharp uptick in block deals (Rs40bn in the last 1M). Promoter selling and pledging activity have been at comfortable levels.

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