The BSE Sensex and the broader Nifty surged to record highs while the rupee strengthened to an 11-month peak against the dollar on Friday as the Bharatiya Janata Party (BJP) led by Narendra Modi swept to a resounding majority in the world's largest election.
Domestic-focused shares such as ICICI Bank and Ambuja Cements soared, reflecting hopes the BJP and its National Democratic Alliance are best placed to revive an economy growing at its slowest in a decade, while exporters like Infosys suffered from a stronger rupee.
The wider-than-expected BJP win spurred several investment banks, including UBS and Deutsche Bank, to raise their targets for domestic shares, as they noted indexes are still relatively inexpensive and thus have more room to gain.
Still, most market gains were later capped and analysts cautioned the rally will now need to be justified, as key tests loom for the government, including the selection of a cabinet.
Other critical areas for investors include the new government's relationship with a central bank focused on inflation and the need to deliver a budget that can reassure markets and credit agencies about the fiscal deficit.
"Clearly financial markets have gone far ahead of fundamentals," said Ananth G. Narayan, co-head of wholesale banking for South Asia at Standard Chartered in Mumbai.
"The next 100 days will be critical for the next government to revive the investment climate."
The strong market gains come less than a year after the country was gripped by its worst currency crisis since the balance of payment crisis in 1991.
Although investors also credit measures taken by the outgoing Congress party and the Reserve Bank of India for stabilising markets, gains have accelerated since the BJP named Modi as its candidate for prime minister in mid-September, with the benchmark BSE Sensex up 22 per cent since then.
As a result, India has gone from one of the most vulnerable emerging countries to one of the favourites among foreign investors; overseas funds have poured more than $16 billion into Indian stocks and bonds in the past six months.
The BSE Sensex gained as much as much as 6.1 per cent to a record high at 25,375,63 before ending the session up 0.9 per cent - a gain that makes it the third-best performer in Asia in dollar terms so far this year after Indonesia and Pakistan.
The rupee strengthened to as much as 58.62 per dollar, its highest since late June 2013, marking a 17.5 per cent gain since the record low hit in August.
The benchmark 10-year bond yield fell as much as 10 basis points to 8.68 per cent, its lowest since Feb. 6.
Investors will now expect the BJP to deliver.
Most immediately, a Modi-led government is expected soon to fill key cabinet posts such as finance minister, which is widely seen as going to Arun Jaitley, a senior BJP leader.
As the BJP focuses on reviving growth and investments, it will need to accommodate the RBI, whose Governor Raghuram Rajan has made fighting inflation a priority since taking the helm of the central bank in September.
The BJP will also need to deliver a budget that addresses the fiscal deficit in a way that is credible to investors and rating agencies.
The high markets hopes were reflected by the rally in domestically focused shares that would benefit most from an economic recovery. Analysts said Indian shares were still not too expensive, with UBS estimating the broader Nifty is trading at around its five-year historical average.
The sub index for banks at the broader Nifty surged as much as 10.6 per cent to a record high, putting its gain at 38.3 per cent so far this year. ICICI Bank surged 8 per cent and State Bank of India rose 7.5 per cent.
Infrastructure-related sectors also gained on expectations the new BJP government would focus on construction projects, sending Ambuja Cements up 6.7 per cent.
But shares of exporters fell, with their earnings expected to be hurt by the surging rupee. Software outsourcer Wipro lost 1.6 per cent and drugmaker Dr Reddy's Laboratories dropped 2.5 per cent.
Analysts warned that the market gains could be at risk should the BJP end up disappointing investors.
Copyright Thomson Reuters 2014