Markets are keeping a cautious eye on the election outcome in Gujarat and Himachal Pradesh. Exit polls offered some comfort showing incumbent BJP continuing its reign in Gujarat state, while a swing towards BJP is foreseen for the smaller state of Himachal Pradesh. This outcome, if true, will be viewed positively by markets as it signals continuity in reforms. BJP would have got a thumping approval for its painful yet transformational policies.

The above outcome would also set the BJP & allies towards achieving simple majority in the Rajya Sabha, thereby garnering strong legislative powers. We believe this would be achieved only by 2022. Having said that, a handicap in the upper house has not prevented the BJP from pushing through key legislations so far like the new bankruptcy code and GST. Moreover, absolute legislative prowess is not a necessity at this stage since improving implementation of existing government programs would be the main focus to enjoy the fruits of hard reforms already initiated.

In this scenario, overt populism could be avoided ahead of mid 2019 general elections. New direct tax code recommendations are expected by end 2018, some of which can be implemented in the 2019-20 budget to be presented in Feb 2019. This would deliver a useful feel good factor just ahead of elections. Following this strategy also provides the government enough time to see through tax collection progress post GST – so you avoid tinkering with tax rates when sustainable tax base is uncertain.

All this is for naught if Gujarat exit poll indications are plain wrong. It happened in 2015 Bihar state assembly elections, when psephologists predicted a tight race led by a Modi wave. A few days later, the final result showed that the BJP was a distant third.

This week the US Fed raised policy rates as promised and is projecting more rate hikes next year, but market has been slow to catch on. The most likely scenario, in our view, is that Fed continues to hike the policy rate while the RBI stays on hold. In this case, the policy rate differential is likely to narrow. This trajectory creates a moderate depreciation bias for the USD/INR (see chart below). Alternatively, if RBI hikes policy rates it would leave the interest rate differential unchanged, but we believe the impact on USD/INR will work through the equity markets. The RBI tightening policy rate when growth is still weak will not be received kindly by equity markets i.e. a depreciation bias for USD/INR. We continue to see the USD/INR at 65 by March 2018 and 66.5 by March 2019