Indian equities' short-term outperformance

There's no dearth of high-quality corporate stories to keep investors interested, but a drop in valuations is likely if the international outlook worsens further

Every major stock market has suffered net losses over the last year, but the Indian market has suffered less than most others. The S&P 500 index—the broad gauge of the US stock markets— is down 17 per cent. Frankfurt’s DAX index is down 21 per cent. The Shanghai Composite is down 15 per cent. But the Nifty is down only 4 per cent and even its US dollar-denominated twin, the Defty, is down only 12 per cent despite the depreciation in the rupee during this period. Is there a clear explanation for the relative outperformance of Indian equities? Looking a little deeper, this strength appears to be based on the optimism of domestic institutional investors. While the foreign portfolio investors have sold Rs 1.85 trillion worth of equity over the last 12 months, and retail investors have been net sellers in direct equity, domestic institutions, including mutual funds, have bought a net Rs 3.1 trillion, which has been enough to almost balance the selling pressure.

As far as equity mutual funds are concerned, the monthly inflows remain strong and those new funds have to be deployed, which means that mutual funds have to continue to buy equities. The dichotomy between retail investors selling direct equity, while investing via mutual funds is somewhat unusual—fund inflows and direct equity investment normally trend in the same direction. While some systematic investment plans (SIPs) have a minimum mandated tenure of six months, most investors have locked in for longer periods and many SIPs are still running, even though retail investors are selling direct equity holdings. There are, however, signs of a dip in fund inflows, with August 2022 registering a 10-month low and a trend of lower renewals can be seen. As far as institutions other than mutual funds are concerned, there is little in the way of attractive alternative investments. Most debt instruments look unattractive in a scenario where real interest rates are negative, and central banks are hiking rates and tightening money supply to combat inflation. Industrial metals are sliding as global demand is slowing and even precious metals are under pressure due to the strength of the dollar.

It is possible that Indian investors are not factoring in all the risks and holding on in expectation that India will do well despite the global slowdown. But while this “uncoupling” theory may be an interesting conversational point amongst retail investors, institutional investors are well aware that India is far too connected to the global economy to decouple during a down-cycle. India is a huge net energy importer; it is enduring a sharp increase in the current account deficit; growth estimates have been slashed as inflation has taken hold; and the rupee has fallen to new lows. Indian markets have always seen severe declines when the global economy is in trouble. However, if the market continues to trend down and mutual fund inflows dry up, there will be more focus on the preservation of capital rather than earning returns. While there’s no dearth of high-quality corporate stories to keep investors interested in Indian equity, a drop in valuations is likely if the international outlook worsens further.