The tug of war

Beyond a near-term reversal, foreign selling and domestic buying of Indian equities may resume

Foreign portfolio investors (FPI) have turned net buyers of Indian equities in the last two weeks after 10 consecutive months of selling. The cumulative outflow during this period has been $33 billion, pushing FPI ownership of the BSE500 to 18 per cent, the lowest since 2012. FPI selling has been broad-based from emerging markets (EMs), with the outgo from several markets as a proportion of market capitalisation the worst since the financial crisis 14 years ago, but India is among the worst affected.

After a wave of heavy selling, markets tend to see a bounce, and we are in the midst of one such. Several indicators of risk appetite, including the value of the trade-weighted dollar, had reached extreme levels, indicating that markets were oversold. 

The yields on US government bonds, which are a proxy of cost of capital globally, have also come down from elevated levels. Higher yields depress asset values, and conversely the fall in yields helps demand for riskier assets. In early stages of these rallies, most investors stay away, given the widespread (and correct, in our view) belief of a bleak future for the global economy. However, for a few weeks, if not a month or two, markets may switch to a “bad news is good news” mode. The underlying belief for this trading behaviour is that markets are forward-looking, and the decline in markets so far has priced in the economic weakness. Further, such evidence increases the probability of future monetary easing, which would then push up stock prices. If these rallies stretch to a few weeks, like this one can, rising stock prices generate a fear-of-missing-out (FOMO) among investors. Such rallies end when either the economic data turns out to be worse than expected, or after a large number of investors have given in to FOMO.

Even as we debate whether the current market levels are pricing in the economic bad news, an equally important question, particularly for the EMs, is whether FPI ownership has bottomed out, and if it can rise steadily over the next year or two, beyond the near-term trading rallies. Our analysis shows it may not.

Over the last five years, we observe a remarkable skew in the growth of the global equity market capitalisation. Of the $23 trillion rise ($74 trillion five years ago to $97 trillion now), the US accounted for as much as 63 per cent. China accounted for 21 per cent, Saudi Arabia 11 per cent, and India 5 per cent, with nearly no growth in the rest of the world. While the listing of Saudi Aramco drove the growth in Saudi Arabia, even in China, annual index returns are negative 2 per cent in the last five years, significantly lagging the 5 per cent annual rise in market capitalisation, implying growth came primarily from new listings.

Illustration: Binay Sinha

Indices have risen 10 per cent annually in the US over the last five years, whereas in EMs and EU they have fallen 1 per cent a year. With “mean reversion” being a common and very powerful theme in markets, some may expect trends in the next five years to be the opposite. However, earnings growth drove all the US returns, and the price-to-earnings (P/E) ratio in the US has fallen over the last five years. There is, therefore, less of an argument for a P/E-driven relative catch-up for non-US markets.

On the other hand, excesses are visible in the market capitalisation-to-gross domestic product (GDP) ratio: The US share of the world GDP has not changed meaningfully since 2010, during which period the US share of global equity market capitalisation rose from 29 per cent to 43 per cent. The US market-cap-to-GDP rose sharply from 95 per cent in 2010 to 140 per cent in 2017 and 160 per cent now, whereas it was range-bound in other regions. At least over the last five years this is not due to higher P/E, and instead due to a rising GDP share of corporate profits in the US. While such trends mean-revert too, underlying changes here are political in nature, and occur over many years.

Thus, for asset allocators, strong returns in the US, particularly over the last five years, may not be a deterrent, and instead are likely to drive higher allocations to the US in the future. This compounds the risk to FPI flows from the weak growth outlook in most EMs, as they grapple with an unwinding US goods demand as well as the tightening of domestic monetary conditions to protect their currencies. In fact, given that global macroeconomic uncertainty persists, FPI selling may resume later this year as downside risks continue to build.

Despite heavy FPI selling, the Indian equity market has been remarkably resilient, with its total market capitalisation in US dollar terms outperforming global equities by more than 20 per cent over the last 12 months (even after adjusting for the listing of Life Insurance Corporation, which added around 2 per cent to India’s market capitalisation). Can domestic flows, which have supported the market, continue? It is analytically useful to divide domestic flows into four parts. 

The first is direct participation by retail investors: Despite continued inflows, their share of BSE500 declined last quarter due to underperformance. As easy returns have stopped (market peaked 10 months ago), retail activity has slowed, and may remain muted. The second is institutional buying by institutions like the Employees’ Provident Fund Organisation (EPFO) or insurance companies, which see steady inflows, a preset proportion of which flow into equities. Third is the large quantum of inflows through systematic investment plans (SIPs), where growth may slow, but a meaningful reversal is unlikely given the behavioural shift needed (actively stopping an SIP requires strong resolve). The fourth are lump-sum allocations to equities, which may slow further given higher interest rates (as discussed in an earlier Tessellatum, Indian sovereign bonds are now cheaper than Indian equities). In aggregate, a meaningful reversal appears unlikely for economic reasons.

Thus, the trend of domestic institutions displacing FPIs from the ownership of the BSE500 is likely to continue, as Indian investors appear to be willing to buy at prices that foreign investors find too high. The latter are responding to the high P/E premium of Indian equities compared to other EMs and global equities. Further, a large proportion of FPI flows to India are through EM or Asia funds (India by itself is not an asset class yet), and such funds may not see sustained inflows for a while. The risk of another surge in outflows from EM funds would therefore continue to be an overhang on the Indian market.

The writer is co-head of APAC Strategy and India strategist for Credit Suisse