Foreign investors dump Indian equities on rising fears of more rate hikes by central banks

• Since the start of September, India has seen FII outflows of close to $3.1 billion, after being a recipient of flows amounting to $18 billion since March.
• Surprise rate hike by Bank Indonesia has triggered risk off trades as many view this as a signal that central banks may not be done with the rate hike cycle.
• If bond yields settle and the geopolitical situation does not flare up, foreign capital flows may return.
  

Indian stocks have outperformed several other emerging markets since March this year, as foreign portfolio investors turned bullish on India on stable macroeconomic indicators. Markets turned choppy as the tide seems to have turned and foreign institutional investors (FIIs) have been selling off Indian equities. In October, foreign investors sold equities worth ₹16,176 crore in the cash market.

Since the start of September, India has seen FII outflows of close to $3.1 billion, after being a recipient of flows amounting to $18 billion since March, says a report by HSBC’s Global Research. The heavy selling is attributed to the sharp rise in US bond yields and the increase in geopolitical tensions in West Asia. This uncertainty has also had an impact on commodities such as crude oil. The key question now is whether FII outflows will continue to weigh on the market or if there will be a rebound.

On the intense selling by FIIs on Monday, Shrey Jain, founder & CEO, SAS Online (a deep discount broker), said: “The US economic data is just not cooling off and the Fed seems to be confused but adamant to take the US in a mild recession. The sooner the US economy starts to cool off the better it may be for equity markets as it will allow the Fed to cut rates. FII flow may be back once rate cut talk starts.”

He attributes the intense selling to the sharp rise in US bond yields touching 5% and expects them to remain higher for much longer. The markets a few months back were expecting a couple of rate hikes and a series of rate cuts in quick succession towards the second half of next year. The markets are now readjusting to a possibility of 50 bps to 100 bps further rate hike or 25 bps to 50 bps rate hike followed by a long pause and no talk of rate cut.

A surprise rate hike opens a Pandora’s Box

What gives legs to this argument is the surprise rate hike announced by Bank Indonesia (BI) last week to defend its currency. This rate hike has come despite low inflation and has opened Pandora’s Box for the rest of Asia on ‘Who’s next?’ says Nomura in its note on Monday. The Japanese investment bank sees BI’s hike as an outlier, rather than the start of a trend. “In our view, the bar for other Asian central banks to hike policy rates is much higher, due to a more laissez-faire approach to currency, ample FX reserve buffers, easing core inflation and still-subdued growth,” Nomura adds.

Despite the recent outflows, India has outperformed its regional peers in terms of market performance. Led by strong macro fundamentals and consistent FII inflows of $21 billion between March and August 2023, India has remained one of the best-performing markets in the region. Even during the consolidation phase since September 2023, India has outperformed all major regional markets.

To understand the impact of sharp changes in US bond yields on FII fund flows in India, strategists have analyzed 21 similar episodes since 2001, where the US bond yield rose by more than 50 basis points within a month. The findings reveal that FIIs have turned net sellers in 14 out of 21 such occasions since 2001, with the sensitivity increasing in the last decade. Since 2010, FIIs have turned net sellers 90% of the time when there is a sharp rise in US bond yields, with a median monthly outflow of approximately $2.6 billion. However, these outflows tend to be concentrated within a month. The current FII outflows of around $3 billion are close to the median of the last decade, suggesting that the large part of the yield impact is likely behind us, unless there is a significant further jump in US bond yields, says HSBC’s Global Research.

It is interesting to note that, despite the recent outflows, FIIs have been net buyers of financials, with positive inflows in most sectors except for technology and energy. On the other hand, domestic mutual fund flows have remained strong, with domestic institutional investors (DIIs) providing support to the market. DIIs, supported by mutual fund flows, have cushioned the market correction, with small- and mid-cap schemes experiencing above-average inflows. This has fueled a sharp run-up in these segments, triggering potential caution in small and mid cap segments.

The question now is whether FII flows can rebound. It is believed that FII outflows linked to the rise in US bond yields have largely played out, leaving the geopolitical situation as the key unknown that may potentially weigh on the market and trigger risk aversion. If the current situation is largely contained, there is a case for an imminent rebound in FII flows. India's strong growth, positive earnings outlook, and attractive valuations in the mid- and small-cap segments provide a favorable backdrop for FII investment. Additionally, FII ownership of the Indian equity market is still below the past 10-year average, and both Asia and global funds have a large underweight on Indian equities compared to their five-year mean holdings.

While the heavy selling of Indian equities by foreign institutional investors has continued, there are indications that the outflows may peak if central banks don’t start hiking rates again. Unless there is a further sharp rise in US bond yields or a deterioration in the geopolitical environment, a rebound in FII flows is possible. India's strong fundamentals and attractive valuations make it an appealing investment destination. However, the market will need to closely monitor the movement in bond yields and the evolving global economic conditions to assess the potential impact on FII flows in the future.