HSBC downgraded Indian stocks to "underweight" from "neutral", citing the government's lack of progress in fiscal or structural reform, little chance of positive surprises from corporate earnings and valuations more expensive than regional peers.
The action stands in contrast to upgrades for Indian equities from foreign banks such as UBS, Deutsche Bank and J.P. Morgan earlier this year, although more recently a handful of brokerages have cut their economic growth forecasts.
"If no concrete measures are taken (by the government) in the near term it could adversely affect the investment climate," HSBC said in a note on Wednesday.
The Sensex has rallied 15.5 percent so far this year as of Tuesday's close, compared to a 8.1 percent gain in the MSCI Asia-Pacific index excluding Japan.
The MSCI India index is trading at a 12-month price-to-earnings ratio of 12.7 times, marking a 10 percent discount to its historical average compared to a 15 percent discount for the region, HSBC said.
"This means valuations are less attractive than in some other markets, such as China," it said.
These factors make Indian equities susceptible to a sell-off given that markets had received $11.8 billion in foreign flows, a big chunk of the $27.6 billion for Asia ex-Japan in the year to date, HSBC estimated.
HSBC also noted that the debt crisis in Europe would act as a drag on equities worldwide and that the potential for quantitative easing in the western world would pose an upside risk to its negative views.
