Problematic 5 months for EMs

FIIs might sell expensive cyclicals, as EMs tend to correct between May and Sept in US mid-term election years

After five years, foreign institutional investors (FIIs) are churning their portfolio. While this is visible from ownership data of the March quarter, strategists claim the rebalancing has gained serious momentum over the past couple of weeks. While everyone's obsessing about the outcome of election results, FIIs have been working on strategies to rebalance portfolios, which so far have focused excessively on expensive defensives. As this class of investors own 25 per cent of Indian equities and have a bigger sway over Indian markets than others, it is relevant to know what they are thinking. So far, India and other emerging markets (EMs) have had a blast, as foreign inflows have continued unabated since January. But as the US heads into a mid-term election phase, Indian equities could face some rumblings.

The period between May and September is known to be a nasty phase for emerging markets, as the US heads into a mid-term election year. Bank of America Merrill Lynch (BofA- ML) says, "Since 1960, on average, EMs lose 1.5 per cent a month in this particular five-month period. This compares with the average gain of one per cent per month in the rest of the four-year cycle since 1960." Though the sentiment towards India remains euphoric, foreign investors are expected to take a step back from cyclicals for now. BofA- ML's quant strategist, Nigel Tupper's positioning suggests an overweight on India but the brokerage says it is time to take a step back from cyclicals.

Even if the next five months could prove challenging for India and other EMs, FIIs are looking at India from a five-year perspective. From being a much-hated market, India now has a halo around it, thanks to Reserve Bank Governor Raghuram Rajan and the Narendra Modi effect. Even if growth does not revive this year, the expectation is that a strong and stable government will eventually result in improved growth and higher corporate earnings. This is not the only reason India is seeing inflows. India has not seen a large-scale sell off, despite the US Federal Reserve's tapering, simply because interest rates in the US have not risen. Contrary to expectations, Citi Research says, 10-year US Treasuries have fallen 60 basis points so far in 2014. Yields continue to be in the 2.55-2.8 per cent range, which is what has led to some rebalancing of the long developed markets and short emerging markets trade. Credit Suisse believes after Friday, equities will be driven by news triggers like allocation of ministries and the Union Budget.