Geopolitical risks

Domestic drivers will support equity markets

The Indian stock markets went through a blip in the last fortnight with a sequence of six losing sessions before a pullback in the benchmark Nifty50 to above the 19,000 level on Friday. The proximate cause was the escalation of the Israel-Hamas conflict, which led to fears of energy-supply disruptions. Prices of crude oil and gas are already up considerably. India’s dependence on imported crude oil and gas is well known. Higher prices would inevitably lead to a wider current account deficit and higher inflation. Since global economic growth is likely to remain subpar and most nations are suffering from higher inflation, there isn’t much headroom to balance the trade equation through higher exports. Guidance from large information-technology firms, mostly formulated prior to the Hamas attacks, indicated no visibility of a fast recovery in demand, which means other exporters will also find it hard to generate volumes. Exports have seen a declining trend in recent months.

Higher global inflation has led to significant monetary tightening and a hawkish policy outlook from central banks. Increased policy rates have resulted in a spike in US treasury yields, which is usually seen as a red flag, indicating a risk-off attitude. When US yields go up, foreign investors tend to pull out of riskier assets, such as rupee-denominated assets, and head to safe havens such as hard-currency government debt. The Federal Reserve’s tighter monetary policy will make it difficult for other central banks to loosen their monetary stance. In any case, the inflation rate in India remains significantly above the target of 4 per cent, which rules out the possibility of a rate cut anytime soon. Higher US-bond yields and policy outlook have led to the selling of over Rs 37,000 crore worth of Indian stocks by foreign portfolio investors. Higher interest rates and tighter money supply are both dampeners for stock-market valuations.

Global factors apart, the Indian markets will also closely track the upcoming Assembly elections and the Lok Sabha elections next year. The markets usually turn choppy at the prospect of political uncertainty. A lot of money might just sit on the fence until there is clear visibility about the next Union government. Christopher Wood, global head of equity strategy at Jefferies, for instance, noted at the Business Standard BFSI Insight Summit this week that the Indian stock markets could see a 25 per cent correction if the Bharatiya Janata Party did not return to power with a working majority in 2024. However, any election-related correction may be of a very short-term nature. As veteran fund manager Prashant Jain noted in the same conference, there is a very weak correlation between elections and market performance over the medium term.

Despite some of these uncertainties, corrections in the Indian stock markets may remain limited owing to some favourable domestic factors. First, domestic demand seems to be strong, and election-related spending might give a boost. Second, inflows into equity mutual funds remain strongly positive. This shows household savings are still flowing into the stock markets, providing big support. On the macro front, despite the recent outflow, India has fairly healthy foreign exchange reserves to deal with volatility in the global currency markets. As things stand, India is in a relatively good position to deal with external risks in the short run. However, if the tensions in West Asia increase further with the potential involvement of other big powers, the outlook on risk assets, including Indian equities, could change significantly.