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Does the Modi euphoria have a sell-by date?

Arvind Yadav | Getty Images

Euphoria surrounding India's new government and strong economic data continues to power stocks higher, but some analysts warn the nation's economic fundamentals don't support further gains.

"This might be as good as it gets for some time," said Shilan Shah, an economist at Capital Economics, noting India's second quarter growth data was welcome news.

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Gross domestic product (GDP) grew 5.7 percent on-year in the second quarter, data released last week showed, up from 4.6 percent in the previous quarter and the fastest pace since the first quarter of 2012. Meanwhile India's balance of payments was in surplus for a third consecutive quarter, data showed on Tuesday.

Excitement over the promise of Prime Minister Narendra Modi who came into power in May coupled with improving economic data is pushing Indian stocks higher.

The Sensex and Nifty surged to fresh record highs on Tuesday. Both indices are up 27 percent year to date, making India's stock market Asia's best performing in dollar terms this year, but whether stocks can sustain their rise is questionable.

Headwinds abound

Those betting that Modiphoria will continue to drive stocks could be disappointed.

The government's budget pledge last month to reduce the deficit to 4.1 percent of GDP from 4.5 percent this fiscal year requires significant spending cuts that will drag the economy, Shah said.

Persistently high inflation is another headwind. Under Governor Raghuram Rajan the Reserve Bank of India aims to bring inflation below 8 percent by January 2015 and 6 percent the following year. Taming inflation isn't easy, however. Consumer-price inflation accelerated to 8 percent on-year in July from 7.3 percent in June; at the going rate inflation could limit the central bank's ability to boost growth through looser monetary policy, Shah said.

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Lackluster progress on Modi's promised reforms on bureaucratic delays, a rigid labor market and poor infrastructure could exacerbate economic headwinds, Shah added.

"As such, growth is unlikely to exceed more than 5-5.5 percent over the next couple of years," Shah said, well below the 7-8 percent the government targeted in three to four years in its budget.

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Kindred views

Monsoon season is expected to yield the lowest rainfall in four years, reducing crop output and boosting inflation through higher food prices, which is another cause for concern according to Taimur Baig, Deutsche Bank's chief economist for Asia.

"We have uncertainty about what's happening with agriculture because of this highly unpredictable monsoon," he said, noting a monsoon-related disruption in power production could also stifle output, while fiscal and monetary policies are likely to remain tight.

"Then there's the issue of lackluster external demand from U.S. and E.U. for all of Asia; Indian exporters will have to deal with that as well," he added.

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However, despite these headwinds, Baig said Modiphoria won't end anytime soon.

"Euphoria translates into more spending and consumption always adds to GDP. This is a fairly seismic change in political leadership, I think market participants will be fairly patient for the time being, there will be a prolonged honeymoon period," he said.

Not all agree. In July, high profile industry commentator Mark Mobius warned that Indian stocks face a correction once the honeymoon ends as the pace of reform will likely prove disappointing.