Mumbai: Indian equities underperformed other emerging markets last week as concerns about interest rate hikes in China and fears of sovereign defaults in Europe added to the negative sentiment at home arising from the political logjam over the controversial 2008 allocation of second-generation spectrum licences.

The Bombay Stock Exchange (BSE) Sensex fell by some 3% for the second consecutive week—the first such fortnightly decline since January, when sovereign debt default fears in Europe initially surfaced and spooked investors.

Still, analysts and fund mangers say a decline beyond another 3-4% is unlikely unless there is a major global economic setback. Some of them say the drop is “healthy" and presents a buying opportunity.

“We expect the markets to stabilize around this level and are selectively buying," said Sadanand Shetty, who helps manage Rs2,693 crore worth of assets at Taurus Asset Management Co. Ltd.

The Sensex dropped 3.9% in dollar terms last week compared with a 2.45% decline in the MSCI Emerging Markets Index. The correction followed a liquidity-driven rally since September that took the index to its lifetime closing high of 21,005 on 5 November. Since then it has already dropped 7% to 19,585.4.

“FII (foreign institutional investor) flows have moderated owing mostly to global factors such as interest rate tightening in China, but this is a normal correction," said Dhiraj Agarwal, director–India institutional equities at STCI Capital Markets Ltd. “Any decent-sized correction has been in the range of 10-14% in the past".

Investors have been speculating that China will increase rates to curb inflation which is at a 25-month high and cool down its economy. Such a move could affect the pace of global economic growth, and spooked investors.

Graphic: Yogesh Kumar / Mint

Huge FII inflows of nearly $12 billion in September and October as part of a liquidity rush to emerging markets in anticipation of quantitative easing measures by the US had stretched valuations and the current drop has restored them to more reasonable levels, many market participants say.

At its closing peak, the Sensex was trading at 20 times its earnings against its historical average of 17 over the past five years. At current levels, the Sensex trades at 18.4 times its consensus earnings for the fiscal ending March.

“Valuations at 21,000 (Sensex) levels and beyond were looking a bit stretched", said Dipen Shah, senior vice-president (private client group research), Kotak Securities Ltd. “From a fundamental perspective, there is little downside risk beyond 19,000 levels and anything close to 18,000 should be a good buying opportunity".

Fund managers continue to swear by the domestic growth story, pointing to double-digit company earnings gains for the September quarter and the 8.5% gross domestic product growth forecast by the central bank. They reiterate that domestic economic fundamentals remains strong despite lower-than-expected factory output numbers.

Growth in the Index of Industrial Production (IIP) fell to 4.4% in September.

“Single-month numbers for IIP can be choppy. One would get a better sense by looking at numbers for a quarter, though the trend is slowing", said Rajat Jain, chief investment officer at Principal PNB Asset Management Co. Pvt. Ltd, which manages Rs5,641 crore worth of assets.

“Industrial capex (capital expenditure) is also set to pick up next year and there are no major concerns on the Indian economy, which stands out among its peers", he added.

Still, concerns about interest rate hikes in China and South Korea to tackle inflation and sovereign default in Ireland have been uppermost in the minds of investors over the past fortnight.

Clarity on these issues will largely determine the market direction over the next few trading sessions. As a 19 November report by Barclays Capital points out, Asian policy tightening could neutralize some of the global effect of the liquidity injection by the US Federal Reserve. In a bid to boost employment and spending at home, the Fed had announced that it would buy bonds up to $600 billion.

“With some economies now exporting more to China than to the US, it is less clear which policy moves are more important for global growth," the report says in reference to the contrasting moves of the central banks of the US and China.

Ashwin Ramarathinam contributed to this story.