How long can Indian stock markets defy the global correction?

The Indian stock markets have shown remarkable resilience in recent weeks even as global equities have faced intense selling pressure. The benchmark Nifty 50 index has fallen only marginally despite the US markets witnessing one of their sharpest corrections in years.

The Dow Jones Industrial Average (DJIA) has plummeted by nearly 1,500 points or around 5% since its recent peak on September 14. In contrast, the Nifty 50 has declined only 2% during the same period. Even more stunning has been the performance of the Nifty Midcap 100 index, which has remained absolutely flat over the past two weeks.

This divergent trend between Indian and global equities is contrary to historical patterns. In the past, any sizable decline in the US markets tended to trigger an even bigger correction in Indian stocks. However, this time the domestic markets have held up well despite the global turmoil.

Recession Fears

The ongoing correction in Wall Street has been driven by intensifying concerns about the prospects of the US and global economy. The US Federal Reserve’s aggressive rate hikes this year to tame multi-decade high inflation has raised fears of the economy tipping into a recession.

Recent economic data has reinforced these worries. Manufacturing and services activity in the US and Europe has slowed down sharply in September as per preliminary PMI surveys. Central bankers have also reiterated their commitment to taming inflation even if it means slower growth. This has dashed hopes of the Fed pivoting to rate cuts anytime soon.

Concerns about an economic hard landing have roiled global financial markets over the past month. The DJIA entered correction territory earlier in September as bond yields spiked on the back of hawkish Fed messaging. Last week’s Federal Open Market Committee meeting cemented expectations of more large rate hikes, pulling down US equities further.

In this context, the resilience shown by Indian markets is noteworthy. Investors are betting that India is better placed compared to developed economies when it comes to dealing with global headwinds.

Indian Economy

The Indian economy has performed strongly so far this year, with GDP growing 7.8% in Q1FY24. This contrasts with slowing growth in the US and Europe. While India’s inflation has also risen sharply, it still remains well below levels seen in the West.

Importantly, India’s relatively lower reliance on exports compared to other Asian economies lends stability in times of global turmoil. Signs of India’s domestic demand holding up well are visible in monthly GST collections remaining robust.

The RBI has also done a comparatively better job at reining in inflation through timely rate hikes over the past year. This has limited the need for aggressive future actions. The rupee has also shown resilience after initial weakness, reducing concerns about imported inflation.

Despite signs of languor in the rural economy, these factors have lent confidence that the Indian economy will remain resilient and emerge as one of the strongest globally over the coming year. Corporate earnings growth is expected to remain healthy despite global headwinds.

Domestic investors have taken advantage of the dip in markets to buy, limiting the downside. FIIs have reduced exposure over the past year and their marginal additional selling now has had a limited impact on the markets.

However, concerns remain on how much longer India can defy the global correction. Any deterioration in the domestic economy or acceleration in FII selling could change the equation quickly. There are also worries that valuations of Indian equities remain stretched despite the global rout.

The true test for Indian markets will come when the US economy begins to visibly crack under the pressure of rising rates. Any sharper corrections in Wall Street driven by recession fears could be difficult to ignore.

No market can remain completely decoupled from global peers in today’s interconnected world. While India’s stronger fundamentals provide some cushion, overcomplacency and euphoric sentiment need to be guarded against.

Positive Vibes

Inflation has emerged as a concern with CPI rising past the RBI’s tolerance limit of 2-6% at 6.8% despite petrol and diesel prices being kept stable for over a year. However, investors may be take succor from the fact that India’s situation is not as bad as that of several other economies, particularly in the West.

Moreover, the rupee has stabilized after touching record lows, reducing concerns about imported inflation. Similarly, healthy forex reserves provide comfort on the external front despite global turmoil. The fiscal deficit has also remained in control thanks to buoyant tax revenues. The stable macro environment gives confidence that India is relatively insulated from global headwinds.

Another reason for the optimism around the Indian economy has been the limited impact of global slowdown on India due to the country’s limited dependence on imports. Exports account for only around 15% of GDP compared to 20-45% for other large economies. This makes India less vulnerable to a global demand slowdown.

A cooling down of demand outside the world will also help India by reducing the price of oil and other commodities that it depends on the overseas markets for, even though it will also hit its own export-oriented industries such as textiles and IT.

On the domestic consumption, India has so far portrayed a mixed picture, with the upper segments of the population continuing to do well, reflected in strong sales of items such as SUVs, while the lower middle class and working class has continued to suffer, as reflected in the poor sales commuter motorcycles and poor numbers coming from rural India for packaged consumer goods companies such as HUL.

Downside Risks

Despite some positive factors that place India better than most of the global economies, the fact is that India’s stock markets are not purely a reflection of its own economic conditions, but also tied inextricably to global liquidity conditions. As such, continued withdrawal of investments by foreign investors are likely to result in an impact on the stock indices eventually, although local retail investors have increasingly got in on the action in the last three years — lured by the sharp rise in stocks.

Foreign investors have been pulling out funds from Indian equities throughout 2022. Their ownership in Nifty companies have dropped from 21.4% in March 2022 to the teens at present.

FIIs sold $17 billion of stocks in FY22 and $6 billion in FY23.30 billion, one of the highest selling faced by any market. Since most of the FII selling got front-loaded, their marginal additional outflows now are having limited impact on overall market direction.

Domestic investors have absorbed this selling. This reflects the strong confidence in India’s economic prospects despite near term challenges. Retail participation has surged since 2020 driven by the ease of investing in stocks through digital platforms.

Millennials are driving this trend, attracted by the high returns from equities compared to traditional assets like gold and real estate. Their investment horizons are also longer. This provides stability to the markets during times of volatility.

There are several other risks that Indian stock investors seem to be ignoring for now.

First and foremost is the risk that seems to have roiled US investors — The risk of stagflation. Economic malaise in the US and Europe will have a noticeable slowing impact on Indian economy, particularly some sectors. This stagflationary mix can drag both growth and earnings.

The second is an acceleration in the FII exodus. If the risk off sentiment globally gathers more steam, it can result in an accelerated pace of FII selling from current levels. This can negatively impact market direction.

Third is domestic liquidity drying up. Retail inflows into equity funds have already dropped considerably from their peak, although SIPs and mid-caps continue to attract retail investors who seem to be expecting strong returns in the coming months.

The valuations of mid-cap and small-cap stocks have risen to unrealistic and stratospheric levels. If the downturn in markets deepens significantly, it risks disappointing these retail investors cautious and triggering widespread redemptions.

India also faces a currency risk. Persistent FII selling can result in excessive weakening of the rupee from current levels. While RBI has shown intent to defend the rupee, its tools are limited in the face of sustained global risk aversion. Currency depreciation risk remains elevated which can stoke imported inflation.

And finally, corporate earnings estimates factor in around 15-20% growth currently. Any slowdown in private consumption or exports that hurts topline growth can lead to downward revisions in earnings. This can change the premium valuations accorded to Indian equities.

The relative outperformance of Indian markets has led to bullish calls that India could finally be decoupling from broader emerging market and global trends. However, no market exists in isolation in today’s interconnected world. Markets may still correct sharply once the global growth visibility deteriorates materially. Investors should be prepared for both eventualities and avoid extreme binary bets in either direction.