When considering the prospects for India's stock market in the coming year, the primary determinants of performance at an aggregate level are the outlook for growth and underlying valuations.

Assuming India's central government remains stable, the outlook for growth continues to improve. Given sustained low consumer price inflation and a reversal in oil prices, it is likely that the central bank (Reserve Bank of India) will ease monetary policy. Leading indicators suggest that nonperforming assets within the banking sector have peaked and are starting to moderate. We believe this should improve the availability of funds to the corporate sector, which has been an issue over the past three to four years.

As the year progresses, the one-time negative impact and initial issues of landmark reforms such as the Goods & Services Tax (GST), Indian Bankruptcy Code (IBC) and Real Estate Regulatory Authority (RERA) will be over and the intended benefits should start to accrue. Lastly, substantial investments have been made on improving logistics infrastructure, which is likely to come online in the next one to two years and should further improve the ease of doing business in India.

Valuations Remain an Issue for Small Caps

Despite the improving outlook for growth, the same can't be said for stock market performance across the market-capitalization spectrum. Valuations continue to be an issue within the small-cap space despite the sharp correction over the past 12 months. Forward valuations for small-cap stocks continue to be higher than normal on fairly abnormal future earnings growth expectations.

Large-capitalization stocks currently represent the most attractive part of the Indian stock market. Valuations are broadly in line with historical averages and expectations for future growth are achievable.

For our India strategy, we have been gradually trimming expensive small-cap stocks over the past couple of years in favor of reasonably priced large-cap stocks, or in favor of turnaround situations where new management is taking the right strategic steps. We continue to stay away from shares of public sector banks despite a capital infusion from the government and despite a better outlook for the resolution of nonperforming assets as the underlying governance-related issues remain unaddressed. The outlook for the private investment cycle is better and a few of our portfolio stocks could potentially benefit from the same.