The recent developments on the Line of Control (unofficial border of India and Pakistan in the state of Jammu and Kashmir) need to be viewed against the backdrop of (1) heightened global uncertainty (troubled European banks, US elections, Italy referendum, December US Fed meeting), (2) rich valuations of the Indian equity market and (3) weaker-than-expected economic recovery. We expect investors to build higher risk premium if one or more unfavorable events play out.

Border events will likely play out over weeks and months
The 'surgical strikes' by the Indian Army against launch pads and terrorist camps across the LoC in Pakistan-Occupied Kashmir (PoK) will add another uncertain variable for investors while assessing the Indian equity market. The border dispute with Pakistan, cross-border terrorism and Kashmir issues have been in the background for the past several years. However, (1) the recent 'surgical strikes' and subsequent developments (in whatever shape and form) and (2) constant analysis by the media of any development will move the issue firmly to the forefront. Small skirmishes along the LoC, which have been ignored so far, will probably get excessive attention.

There are other variables to consider, which make short-term predictions futile

We note that there are several variables at play over the next few weeks—(1) normalisation or escalation of matters between India and Pakistan, (2) containment or contagion of the problems in certain European banks, (3) outcome of US elections, which is still too close to call, (4) Italy referendum and (5) December 2016 US Fed meeting. In our view, investment risks have gone up over the past few weeks but so far the issues look manageable.

Valuations are high and vulnerable to any meaningful increase in risk though
The Indian market’s rich valuation does not leave much scope for any meaningful increase in investment risk. In our view, low global yields for an extended period of time due to the loose monetary policies of the major central banks have resulted in a fair bit of mispricing or misunderstanding of risk. Markets perhaps mistake low yields for low investment risk. As we have argued before, investment risks have not changed much over the past few years; if anything, the world and global economy are in a far more uncertain state. More importantly, earnings uncertainty (equity risk premium) for the Indian market has gone up meaningfully across sectors (for example, earnings of even hitherto-steady sectors such as IT and pharmaceuticals are increasingly tough to model), which should logically offset some of the decline in the so-called risk-free rate (due to a better macro situation and lower interest rates).

Hunker down and hope for the best
In our view, it would be best to reduce some risk in the portfolio given that the Indian market has done exceedingly well in the past three months and valuations are fair to full for many stocks in our coverage universe. Many large-cap, mid-cap and small-cap stocks have gone up significantly in the past three months. We note that several of the large-cap and mid-cap stocks in our coverage have gone up over 30% in the past three months alone.

This is an excerpt from Kotak Institutional Equities latest Strategy note dated October 3, 2016. Copyright 2016 Kotak Institutional Equities (Kotak Securities Limited). All rights reserved