FPIs may wait for some steam to blow off a red-hot Street

With the near-uninterrupted 17% rally from the 2023 lows in March taking domestic benchmark indices to record highs and pushing share valuations to elevated levels, there are concerns that the market may be overheated in the near term which could result in foreigners moderating their purchases of local stocks.

Foreign portfolio investors (FPIs) net sold shares worth ₹1,998.8 crore on Friday – their first day of selling after six days and the second in July so far – resulting in the Sensex and Nifty dropping over 1% each.

Though it might be premature to conclude that it may be the start of a reversal, analysts said the pace of flows seen since March is more likely to slow due to the effects of continued Quantitative Tightening (QT) by the US Federal Reserve and the weaker-than-expected first-quarter earnings by blue chips such as Infosys, Hindustan Unilever and Reliance Industries.

“The balance sheet size of the US Fed is coming down due to QT. And therefore, we expect the quantum of flows from foreign investors, particularly those in Europe and the US, into emerging markets to moderate in the near term,” said Manishi Raychaudhuri, head of Asia-Pacific equity research at BNP Paribas Securities. “Even as India continues to remain a relative favourite among the FPIs, the total quantum of flows might come down. From such a high base, moderation is likely.”

Since the end of March this year, FPIs have pumped in ₹1.5 lakh crore ($17 billion) into Indian equities – the highest cumulative tally since the October 2020-March 2021 period. The renewed flows have been driven by expectations that the Fed is set to signal that the rising interest rate cycle is peaking, resulting in a weakening dollar.

When the dollar falls, the appetite for riskier assets such as emerging markets goes up.The Street will watch out for the outcome of the US Federal Reserve’s rate-setting meeting this week to judge whether such hopes were justified.

NATURE OF FOREIGN FLOWS
Analysts said flows into emerging markets like India began with passive money – known as exchange-traded funds (ETFs) – followed by actively-managed funds.

“Our analysis shows that until May, the bulk of the money came from passive funds (ETFs),” said Sanjeev Prasad, co-head at Kotak Institutional Equities.

Prasad said all sub-categories of FPIs have a role to play in the current rally, but a large portion of the foreign inflows may have come from hedge funds and prop banks.

The renewed flows into India from late March were on account of a shift in investor interest from China to India.

The current rally is purely a momentum trade because of China’s underperformance, said Prasad.

“As sentiments and momentum strengthened, active investors started putting money into India because of their pent-up frustration with China-related factors,” said Prasad.

The fresh flows resulted in India’s weight in the benchmark MSCI Asia ex-Japan shooting up from about 10% a year ago to a high of up to 18%. Currently, this is around 16-16.5%. Hong Kong and China alone account for 43% of the MSCI Asia ex-Japan index.

“That’s a very serious expansion that happened for the Indian markets and the passive money, by definition, linked to the benchmark weight is forced to keep up the flows,” said Raychaudhuri.

US INVESTOR OPTIMISM
US funds have been a big driver of flows into India since March. A portion of such flows into India has been driven by optimism that India is the next big growth engine in the region, that has the potential to replace China which has been plagued by slowing growth and debt as a hot favourite investment destination. Simmering tensions between the US and China have also prompted investors to consider India, which is perceived to be more stable.

After seeing a minor contraction in their share of India inflows at the start of calendar 2023, the pace of investments from the US-based FPIs began to accelerate.

The equity assets under custody (AUC) of US-based FPIs stood at 21.53 lakh crore, making them the largest owners of domestic shares among overseas investors at 7.12% of India’s total 302.1 lakh crore, or $3.7 billion, in market capitalisation.

“The US (investor) is aware of the growth story that is India and is always looking to invest in the next big thing,” said Jay Woods, chief global strategist at Freedom Capital Markets. “The growth story and potential are phenomenal from an investing public that is looking for new ideas.”