The stock market is on a high in the first one month and one week into the new calendar. The bellwether Sensex is up nearly 15 per cent after a dismal 2011, when a combination of domestic factors (such as high interest rates, high inflation and the much-talked-about policy inertia at the government level) and global factors such as the euro zone crisis and fear of recession in the US dragged the market.

With the Union budget only a month away, the focus of the market will slowly shift to the possible budget proposals. Will there be a cut in the Securities Transaction Tax (STT) to boost equity market sentiment, will there be bold reform steps such as opening up of multi-brand retail to foreign investors, or a move to attract investment in the infrastructure sector ranging from ports, airports, roads, construction?

The buzz around all of the above and more may trigger a pre-budget rally in the market over the next few weeks.

But given the macro-economic situation, the finance minister faces a few tough challenges, ranging from ballooning deficit to a slippage in revenue collection, to possible slump in exports and the urge to initiate some much-needed measures to revive growth in the economy.

Most of all, the market will be waiting for some clarity on the implementation of the direct taxes code (DTC) and the goods and services tax (GST), both of which are stuck in the quagmire due to lack of political consensus and objections by states.

Rationalisation of the myriad subsidies on fuel, fertiliser and food fronts; any cut in social sector spending in order to cut costs; and a possible higher allocation towards the infrastructure sector to bridge the gap it suffered this year are some of the other issues that will be on the watch list of investors.

The market will also be keenly watching the government disinvestment programme for the new financial year after a disastrous show on this front in the ongoing financial year. As fresh signals emerge on these fronts in the run-up to the budget, the market is likely to move either ways.

Historical data do not suggest any pattern in market movement ahead of the budget. In fact, on only four occasions during the past nine budgets has the market seen a pre-budget rally. The biggest of these rallies ahead of a budget were seen in 2006 (up 7.7 per cent) and 2005 (up 6.6 per cent) (see chart).

Sanjay Sinha, former CEO of L&T Mutual Fund and founder of Citrus Advisors, is of the view that pre-budget expectations will start building up, depending on the outcome of the state elections, especially the Uttar Pradesh results, which will be known by March 6.

“There are expectations that the Manmohan Singh-led United Progressive Alliance may put up a better show in the state elections, which will help the finance minister go for a bold budget,” Sinha said.

Expectations that the Reserve Bank of India will begin its rate cut exercise from April, if not in March, will give a shot in the arm to the bulls, experts said.

For many investors, the ongoing rally may have come as a surprise as not many things have changed from last year. But Yatin Shah, executive director of IIFL Private Wealth Management, said he expected the market momentum to continue at least till the budget.

“The market momentum is strong and we expect the rally to sustain for some more time,” said Dhiraj Agarwal, director of institutional equities at Standard Chartered Securities, a foreign brokerage.

Last month, the Reserve Bank of India (RBI) showed its intention to reverse the two-year monetary stance by cutting the cash reserve ratio or the portion of deposits banks have to keep with the central bank by 50 basis points last month. Steps from the government such as allowing individual foreign investors (qualified foreign investors or QFIs) to buy Indian stocks directly and the institutional placement programme (IPP) to help Indian promoters (including the government) sell shares to institutional investors via the auction route are aimed at boosting flows into the equity market, which fell about 25 per cent in 2011.

There was also enhancement of limits for FII investment in government and corporate bonds.

Ajay Parmar, co-head of investment banking at Emkay Global, said foreign inflows will continue for at least next 3-4 months. “Foreign investors are pre-empting interest rate cuts and a drop in inflation,” he explains, adding that the government decision to allow 100 per cent FDI in single-brand retail and allowing QFIs to invest in Indian stocks have boosted FII confidence.

He expects the government to unveil confidence-building steps in the budget, going by the recent noises made by top government functionaries.

“For a change, the government is trying to reach out to investors. The government is taking steps that are in favour of the market. Hopefully, the budget will demonstrate it further,” Parmar said, adding that a possible cut in STT will also augur well for market sentiment.

According to Agarwal of Standard Chartered Securities, a bulk of FII money this year has come to last year’s beaten-down sectors such as infrastructure, engineering, banking and the like. So are we building too much expectation surrounding a possible rate cut in April and bold reforms in the budget?

“One thing is for sure, if the rate cuts do not happen in April, we will see a correction,” fears Parmar. Sinha of Citrus Advisors echoed similar fear, saying foreign investors may press the sell button if the rate cuts are not begun by April.

All said it would be an interesting 2-3 months from here on.

(With input from Ravi Ranjan Prasad)

rajeshabraham@mydigitalfc.com