How and why FIIs will continue investing in India

India still looks relatively good versus most commodity or other export-driven emerging markets

India has received $15 billion of net foreign institutional investor (FII) equity inflows year-to-date out of the $17 billion inflows into Asia Pac (ex-Japan / China / Australia). FII ownership is at an all-time high at 21 per cent. Domestic institutions have been net sellers with no signs of retail inflows picking up. So, this has many worried that the Fed's quantitative easing (QE) tapering may lead to a collapse in FII inflows - especially given increasing political risks later this year. Valid concerns - and one should expect more global cross-asset volatility, which is generally negative for risk assets, including emerging market (EM) equities

However, QE tapering is a relatively bigger risk for a disorderly exit from crowded global rates and credit positions. And it is also a necessary condition for sustainably stronger equity markets and a more robust underpinning to global growth. Global equity investors don't necessarily fear rising bond yields - if driven by growth (provided inflation expectations remain anchored, which seems likely). Global investor positioning is still largely neutral in equities into which inflows continue selectively (US, Japan), mainly at the expense of money market funds but not bond funds as yet in a big way. Central bank policy still remains coordinated and supportive of growth. So, I expect episodic volatility to provide attractive entry points for global equity investors in the coming months.

India still looks relatively better versus most commodity or other export-driven emerging markets: lower commodity prices, an improving fiscal / current account outlook, and the only one in a major EM economy in an interest rate easing cycle. Weak sentiment is a good time to buy, and headline index valuations are middling, not expensive - and there are significant stock picking opportunities in the broader market. The risk of a sharp macro deterioration due to pre-election populism seems low, given the UPA government's renewed focus on the economy - with a greater proportion of younger / educated voters and competition from a likely Narendra Modi-led BJP, it has to show better economic growth and governance. An unstable coalition government is indeed a risk, but not probable enough as yet to deter FIIs. So, FII equity inflows should pick up once the INR stabilises.

FII inflows since 2012 have been very concentrated - from very few FIIs and into some 30-odd stocks (mainly large caps in banking, consumer, IT and pharma). Global equity inflows have not reached most India-dedicated or even Asian funds, with exchange traded funds and non-benchmark investment strategies being relatively bigger beneficiaries. As global equity inflows pick up, actively managed funds should benefit.

And there are fundamental reasons to expect greater market breadth and depth, with expensive "quality" stocks becoming an increasingly crowded and risky trade. Lower food inflation (assuming normal monsoons) should enable more rate cuts. The recent pick-up in government spending should also help revive growth and market liquidity. Investors are sceptical but there is progress on resolving the power sector's distribution and coal supply issues, railway capex is underway to address critical bottlenecks, a gas price hike is inevitable to incentivise new E&P investments and CCI approvals for about $24 billion of projects so far will also drive a capex revival by the year end.

To quote Sir John Templeton: "Bull markets are born on pessimism, grown on scepticism, mature on optimism and die on euphoria." In my view, we were at the pessimistic stage in August 2012, and currently are in the scepticism stage. A long (albeit volatile) way to go…

The author is managing director and head of equities, Deutsche Equities India.

Views expressed are personal