By B Prasanna

India’s story, over the last few years, has been one of hope and despair. The pre-election rally that started in September 2013 was a classic case of hope, and equity markets responded with a 20% return in the run-up to the election. FPIs had participated in the rally (Sept 2013-May 2014) with inflows of approximately $15 bn.The recent surge in FPI flows in March brings to mind the same question: Is this a repeat of the previous election rally, or is it different this time?

Predicting FPI flows is tantamount to crystal gazing, but, if one observes historical data, FPI inflows have always been high in an election year—Rs 65.78 bn in 1999, Rs 389.65 bn in 2004, Rs 834.23 bn in 2009 and Rs 970.54 bn in 2014. India has witnessed positive pre-election FPI inflow in two out of three instances with 2009 period being an outlier. The 2009 period witnessed the great financial crisis that had a huge effect on fund flows. The current pre-election rally has started much later, and has been shallower than the typical past rallies and it will be interesting to look at how these FPIs are expected to behave, given the domestic and global macro backdrop. There has always been an uncertainty discount that was attached to Indian markets by FPIs owing to elections. However, post the surgical strike 2.0, the uncertainty discount seems to have reduced with markets expecting a stable government. This has resulted in a catch-up rally in March 2019.

The sudden change in the mood of the FPIs has taken many market participants by surprise, and they cannot be blamed. Just before the surgical strike 2.0, FPIs had been net sellers to the tune of $4.5 bn till February 2019. The FPIs had reduced their overweight position in India with the weight in the Global Emerging Market (GEM) funds down to 9.4% while that in the Asia ex-Japan at 11.8%, down from the 2015 peak of 13.3% and 14.8%, respectively. This brings us to the issue of continuity of such flows going ahead. FPI flows in FY20 will be a result of an amalgamation of US Federal Reserve policy, global and domestic macro environment, the election outcome and improving corporate earnings driven by improving bank balance sheets.

The current Fed chairman, after hiking rates four times in 2018, changed gears sharply and turned “super dovish”. Market expectation has also swung from three hikes in 2019 to a pause or even a cut. Fed’s change of heart, coupled with global QE and subdued inflation, has kept US 10-year yields under check, resulting in a bull flattening. The US 10-year yield is down from a peak of 3.25% to 2.44%. Lower interest rates are expected to reduce the risk premium and, hence, the cost of equity, and support equity markets, ceteris paribus.

The exercise of predicting recessions using the inverted yield curve argument has its own pitfalls although empirical evidence suggests that the US has witnessed recessionary conditions two years after every yield curve inversion. However, this may not pan out this time around, with the US unlikely to slip into recession just yet and is instead going to face a growth slowdown. The extent of the inversion is important as well as the length of time the inversion sustains. Hence, in this period of bull flattening, equities are likely to remain positive and fund flows are expected to move to relatively higher growth emerging market economies, including India.

The FPI positioning in Indian equity markets is another supportive factor. Excluding the March 2019 inflow number, India on a 12-month trailing basis has witnessed net outflows. Since 2009, India on 12 month trailing basis, has witnessed outflows only on four occasions (financial crisis, EU financial crisis, yuan devaluation and the recent trade war). This typical FPI capitulation was subsequently followed by a positive inflow. The expectations of the results of the upcoming general election may have provided the basic impetus for inflows. This is also supported by a good combination of improving corporate profitability and expectations of benign nominal interest rate. FPIs have approximately $380 bn of Indian equity assets under custody as of February 2019. Any change in the stance of the GEM Portfolio Managers, who are currently neutral on India, might further drive significant inflows to the Indian market. However, some caveats must be noted, and FPI flows will be frontloaded given the busy calendar in H1FY20. This includes RBI policies, the poll outcome and the full Union budget in June.

After these events, over the rest of the fiscal year, the framework will shift to one of “business as usual”, and flows will depend mainly on improvements in corporate profitability, where the consensus is of expected profit growth north of 20%. Any disappointment won’t be taken lightly, given that the Indian equity market valuations are relatively at the upper end, with MSCI India trading at 18x 1-year forward earnings. Also, the Indian market is at approximately 40% premium to MSCI Asia ex-Japan, making it one of the most expensive markets in Asia. The other risk is inclusion of China’s A-share index in the MSCI indices. Its inclusion means a reduction in India’s weight by 20 bps starting from May 2019 to November 2019, resulting in expected outflow of $3.8 bn.

Thus, FPI flows in H2FY20 will depend on India-specific fundamental issues, and it is here that the government and corporates will play a significant role. The new government should introduce a new set of reforms, reduce bottlenecks in the system, continue to help the banking sector clean up balance sheets and improve credit offtake. The steps taken to address agrarian crisis and consumption slowdown should show positive dividends. All these factors should help Indian Inc achieve 20% profit growth and support the current high valuations, thereby supporting the continued FPI interest in Indian equity market.

(The author is the Head, Global Markets Group, ICICI Bank)