India to get higher FII flows after US rate cut

Indian stocks could attract higher foreign investor inflows this year, with the US Federal Reserve cutting its policy rate by an outsized 50 basis points, the first cut in four years and signaling another 50 bps cut over the rest of the year, as per analysts.

They rule out a runaway rally, though, given the steep valuations across large swathes of the market, expecting large caps to outperform broader markets, aided by domestic institutional flows and a possible Reserve Bank of India (RBI) rate cut by the year-end.

"Generally emerging markets (EMs) like India tend to attract more foreign money in a declining interest rate cycle, courtesy of a carry trade, which sees foreign institutional investors (FIIs) borrowing cheaper at home to invest in higher yielding, riskier EM assets," said Andrew Holland, CEO, Avendus Capital Alternate Strategies.

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Holland expects a gradual rally rather than a raging one with large cap lenders and shadow banks likely outperforming broader markets, which could witness profit booking, a trend seen over the past few trading sessions and particularly on Thursday.

Nifty, Sensex records

After the overnight Fed rate cut, the Nifty and Sensex surged to fresh record highs in the first hour of trading on Thursday, before paring gains sharply thereafter to close only marginally higher. The Nifty hit a fresh high of 25,611.95, up 0.9%, before erasing most of its gains to close 0.15% higher at 25,415.80. The Sensex similarly rallied a per cent to a fresh high of 83,773.61 before paring gains to close up 0.29% at 83,184.80.

Despite the modest rise, the benchmarks outperformed the broader markets, where profit booking dragged down Nifty Midcap 150 by half a percentage point to 21,965.15 and the Nifty Smallcap 250 by 1.11% to 18,270.40.

HDFC Bank and Kotak Mahindra Bank contributed 0.13% of the Nifty's 0.15% gain.

FII inflows in the current calendar year at ₹73,782 crore lag domestic institutional investors (DII) inflows of ₹3.2 trillion.

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"While the 50 bps cut was larger than expected, the 100 bps cut signalled earlier for this year was priced in by markets," said Ashish Gupta, CIO, Axis AMC, citing the US 10-year bond yield which was up 3 basis points at 3.73% at the time of writing.

While Gupta doesn't expect markets to "get ahead of themselves" he said lower "global rates" meant "lower global cost of capital" which was good for financial assets.

Indeed heavy domestic and FIIs buying has driven Indian stocks, especially small and midcaps to highly overvalued territory. For instance, while the Nifty currently trades at a price to earnings multiple of 24.82 times against a historic average of 24.73 times, the Nifty Midcap 150 trades at a 46.85 P/E multiple against a historic 36x while Nifty Smallcap 250 trades at 35.78 times (28.7x).

Finding value in overheated market

Citing the overvaluations across sectors, Sanjeev Prasad, co-head and MD of Kotak Institutional Equities, finds "value" in banks in the large cap space which he termed “overvalued”. He advised caution to investors in broader markets terming the small caps and midcaps to be "highly overvalued."

The rupee, meanwhile, gained 7 paise to close at 83.68 to the dollar while the Indian 10-year bond yield gained 9 bps to a provisional close of 6.87%, reinforcing analyst views that a cut in US interest rate was priced in by the market .

Economists expect RBI to hold the rates steady in its upcoming monetary policy committee meeting in October, given the focus on curbing food inflation but to likely cut in the December policy. “I do not think the MPC (monetary policy committee) would lower the repo rate as a reaction to the US Fed cutting rate. Even last week, the RBI governor said that rate cut will depend on the inflation trajectory,” said Madan Sabnavis, chief economist, Bank of Baroda. “It would be interesting to see how the new members of the MPC would view this decision by the Fed. A cut in December is possible though.”

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The government is expected to appoint new members to the MPC in October, replacing those appointed in October 2020. According to Dharmakirti Joshi, chief economist, Crisil, India’s monetary policy is in a way dependent on what happens to food inflation. “Whether the Fed cuts by 50 bps or another 50 bps, if food inflation does not show signs of softening on a durable basis, the central bank’s target of 4% inflation will be more challenging to achieve. The management of food inflation will be very critical for RBI to cut rates,” said Joshi.