The overall worldwide economic situation appears to be improving with the successful weathering of the credit freeze.  The US Fed has committed itself to a policy of infusing liquidity till inflation returns. Investor confidence is showing signs of returning with spreads reducing in the credit markets. So also have other central banks although to a less explicit extent. The temporary panic has passed and rationality is returning to the markets. The way ahead of us clearly points to the return of inflation. Hence stocks are clearly the assets to own in the current scenario. However there are two pathways open to us. The easy money policies can lead back to the old habits of excessive leverage and current consumption or if channeled properly can lead to investment and saving for the future.

The first pathway will likely lead to a commodity boom and a bigger crash later on, however the second option with directed government infrastructure spending can lead to an investment for the future and hence sustainable growth.

The other issue is where this liquidity will be channeled. If investment or consumption happens in the developed markets emerging markets could be starved for capital and hence have slowing economies. However given the fact that there is likely to be no or negative growth in the developed economies capital could flow to emerging economies as investors look for growth and return rather than safety. Also low or negative consumption growth in the developed economies will keep commodity prices low which in turn will give a fillip to emerging economies like India.

Focusing specifically on the Indian context, the government and central bankers have acted swiftly and decisively. The central bank has undertaken several measures to infuse liquidity. The government has also announced infrastructure spending plans. Infrastructure companies which were threatened with bankruptcy are now in a much more favorable environment with low interest rates, availability of funding, low commodity prices and expectations of government infrastructure spending.

On the other hand Indian consumers have always been large savers than spenders. While easy credit availability in India did lead to a consumption boom it was not excessive to the levels in the global economies. The positive aspect is the pay revision announced for government employees. This should result in higher consumption and spending and reduce the tendency towards excessive savings and hence a more balanced economy.

Specifically on mid and small cap stocks high operating leverage was a major concern where a decline in topline results in disproportionately larger decline in bottomline and margins. However what needs to be noted is that in a recovering environment this will lead to a huge benefit to the companies. The scheme would position itself to benefit from these companies.