Mint Explainer: How FPIs rediscovered their love for Indian markets | Mint

Mint Explainer: How FPIs rediscovered their love for Indian markets

The Indian stock market has seen an 11% rally from the lows seen on 26 October, bolstered by FPI inflow. (AFP)
The Indian stock market has seen an 11% rally from the lows seen on 26 October, bolstered by FPI inflow. (AFP)

Summary

  • With FPI flows expected to sustain, there is a strong possibility that the Sensex and Nifty could outperform midcap and smallcap indices, as global investors have a penchant for large-caps

Foreign investors have resumed buying Indian stocks after a two-month hiatus, reversing a trend that saw them pull out $4.7 billion from domestic equity markets. The sell-off saw benchmark index Nifty correct almost 7% from a high of 20,222.45 in mid-September to a low of 18,838 in the last week of October. Mint takes a look at the factors that caused foreign portfolio investors, or FPIs, to return to India. 

The global economic context

The outflows from Indian markets had corresponded with a steep jump in the US 10-year government bond yield, which had spiked from 4.1% at the end of August to a 16-year high of 4.99% around mid-October. The trend reversed after the US Federal Reserve decided to keep its benchmark rate unchanged on 1 November, and on slower-than-expected growth in US retail prices.

US markets interpreted this as a lagged effect of 11 straight rate hikes from March 2022 to July 2023, thanks to the Fed’s attempts to rein in inflation. The Fed, experts said, could actually start cutting rates in the second half of 2024.

This caused US bond yields to fall and sparked a global stock market rally with funds flowing back to emerging markets, including India. The 10-year US government bond yield has slumped to 4.15%, from 4.99% in October, thanks to the US markets pricing in the view that interest rates had peaked.

The Indian stock markets have witnessed an 11% rally from the lows seen on 26 October, bolstered by $4.31 billion in FPI investments since November. The benchmark Nifty50 closed at a high of 20,901 on Wednesday. The index hit a record high of 21006.10 on Friday and settled near those levels.

The US bond yields and FPI relations  

The correlation between US bond yields and the FPI movement is that a rise in the former often leads to outflows from emerging markets like India, whereas a decline prompts inflows. 

This becomes more evident when one compares the bond yield to the Sensex earnings yield, which is an inverse of the price-to-earnings, or PE, ratio.

For instance, FY21 saw the highest-ever annual FPI inflows, amounting to $37billion. The average Sensex earnings yield that year remained flat at 4.02%. However, the US bond yield plunged to an average 0.87% from 1.82% in the preceding financial year. The Sensex return that fiscal year was 75.2%. 

In FY23, the bond yield rose a whopping 112% as the Fed began raising the benchmark interest rate from near zero, while the Sensex earnings yield rose just 26.5%, causing FPIs to sell $5 billion. The Sensex returns were a negative 0.5%.

This fiscal year, the bond yield has risen by 21% against the Sensex yield of 2.65% as the Fed continued its rate hikes through July, taking its benchmark interest rate to as high as 5.5%. In the next two Fed policy meetings, the rate was unchanged. With one more meeting pending on 12-13 December, Wall Street will carefully parse the Fed chair's commentary on cues for possible rate cuts next year.

The status quo on policy rates and the cooling of inflation these past two months have rekindled the animal spirits. Global stocks have rallied, with India being a beneficiary of the FPI inflows, coupled with strong domestic institutional flows anticipated at 2 lakh crore, with SIP monthly flows rising to 17,000 crore.

This has driven a 14% rally in the Sensex in the calendar year to date. This lags behind the smallcap and midcap counterparts, which have risen 40-50% since March. 

Currently, the Sensex's trailing 12-month PE ratio is 24.61, compared to the BSE Midcap 150's 27.87 and the Smallcap 250's 27.26. Though these valuations look stretched, the Sensex is expected to start outperforming both. 

Road ahead

With FPI flows expected to sustain, there is a strong possibility that Sensex and Nifty could outperform Nifty Midcap 150 and Nifty Smallcap 250, as global investors have a penchant for large caps, which haven't moved much in the past two years.

This outlook is bolstered by an expected annual earnings growth of 17-18%, driven by the government's increased spending on infrastructure and the hope around consistent policies if the current ruling political party wins the general election next year.

This implies that in the event of a market correction, the benchmark indices Sensex and Nifty are likely to see a smaller decline compared to their midcap and smallcap counterparts. Conversely, should the markets see an upturn, these indices are expected to outperform the smaller ones, showing a greater upward trajectory.

"My feeling is that going forward, large caps will start outperforming the mid and small caps with relatively cheaper valuations and investors allocating more money to large caps," said A Balasubramanian, MD &CEO, Aditya Birla Sunlife AMC.

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