Mumbai: India’s benchmark stock index rose to its highest level in two months as investor confidence won a boost from a European agreement to stem the continent’s debt crisis and the US economy grew at its fastest pace in a year in the third quarter.

Receding global risk aversion and higher foreign fund flows will likely lead to short-term gains, but analysts cautioned that the rally may not be sustainable for long, given domestic headwinds such as high inflation and lingering concerns about the global economy.

The 30-share BSE benchmark Sensex rose 515.97 points, or nearly 3%, to close at 17,804.80 on Friday, the first day of trading after the Diwali break.

The Bull at BSE, Mumbai Stock Exchange (File photo)

European leaders persuaded bondholders to take 50% losses on Greek debt and boosted the rescue fund by €1 trillion (Rs 69 trillion today) at a summit meeting that ended on Thursday.

Last-ditch talks with bank representatives led to the debt-relief accord aimed at solving the Greek sovereign debt crisis and preventing speculation over the worsening debt levels of Spain, Italy and France from ravaging the euro zone and wreaking global economic havoc.

Measures include recapitalization of European banks, a potentially bigger role for the International Monetary Fund, a commitment from Italy to do more to reduce debt and a signal from leaders that the European Central Bank will maintain bond purchases in the secondary market.

Graphic by Yogesh Kumar/Mint

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Risk-averse fund managers, who were sitting on cash, have contributed to an emerging markets rally after positive news from Europe started trickling in, said a 28 October note by Donato Guarino of Barclays Capital.

“We maintain our cautious stance and would not chase the rally. We are concerned that in Europe, implementation fatigue may surprise a market that has already priced in a very positive outlook," Guarino’s note said.

The European bailout package is the first step towards addressing concerns over debt, but details of the deal and its implementation are still not clear and it is likely that Europe will continue to be a cause of market volatility in the next few months, said Nick Paulson-Ellis, country head of the Indian arm of Portuguese investment bank, Espirito Santo Securities.

“I do not expect a strong rally in the Indian market as both domestic concerns such as inflation as well as concerns on Europe persist," said Paulson-Ellis.

Food inflation in India crossed 11% for the week ended 15 October. Indian companies are also facing an earnings squeeze as margins have fallen across sectors owing to rising input costs and limited pricing power in an economy that is projected to grow at a slower pace than the average rate of 8.4% over the past five years.

A fall in the risk perception could nevertheless lead to an extended rally for the next few trading sessions.

“While foreign investors are long on Indian indices, there is a considerable amount of short positions by domestic investors and we could see some unwinding in the coming days, adding to the rally," said Siddharth Bhamre, head of derivatives at Angel Broking Ltd.

Both domestic and global concerns have led foreign investors to shy away from Indian equities this year, causing them to sell $314 million (around 1,535 crore today) worth of equities to bring down the Sensex by 13.4%.

Other emerging markets have suffered a similar fate owing to increased risk aversion, with the MSCI Emerging Markets Index down 13.7% this year so far.

Bloomberg and Ashwin Ramarathinam of Mint contributed to this story.