S&P outlook upgrade may be a game-changer for markets

Further inflows into local currency corporate bonds likely; weaker euro may offset pressure on EM currencies

Global ratings firm S&P's decision to change India's sovereign rating outlook from 'negative' to 'stable' should have a beneficial impact on India's bonds market. Standard Chartered Global Research says though foreign investor portfolio in government bonds is fully utilised, inflows into local currency corporate bonds are increasing and a change in outlook will drive further flows.

The rating outlook change is relevant now, as the US Federal Reserve is set to end its monthly bond-buying programme in October, ahead of a potential rate hike. This has been a big risk for Indian markets, as the momentum in equities has been driven by liquidity from foreign investors. A reversal in flows could have a significant impact on India's financial markets. However, with the change in sovereign rating outlook, India is better placed to battle a taper tantrum.

For starters, the situation in select emerging markets (EMs) like India is significantly better than it was in 2013. Second, economists are drawing inferences from the past, when the tightening cycle commenced in the US and its impact on EM assets. Historically, equities (in developed and EMs) have done well during times of rate tightening. According to BNP Paribas, there have been four major episodes of US bond yields rising but capital flow data for EM funds is available from 2001 onwards (for three instances).

The flow data show that EM funds saw outflows from May 2004. In the second episode of bond yield appreciation without a rate hike (from December 2008 to March 2010) didn't lead to any outflows from EM funds, instead saw inflows of $51 billion during this period. In the fourth and most recent round of bond yield increases (between July 2012 and May 2013) did not see any outflows in the initial phase but saw outflows from May 2013.

BNP Paribas' Manishi Raychauduri believes commencement of rate hikes can reduce inflows into EMs temporarily but not structurally. Recent flows into countries such as India, China and Korea have been driven by country-specific policy measures and earnings estimates. These fundamental drivers will continue to drive inflows, he believes.

Goldman Sachs International's economics research says with the euro weakening, pressure on EM currencies will be offset. The rise in long-term rates will be moderate compared to 2013. With the euro headed towards 1.20 against the dollar, economists believe it could be a game changer for EMs.

The cherry on this cake comes from the fiscal bonanza the government is expected to reap from lower oil and commodity prices.