November Rain On Dalal Street? FII Selling Likely To Continue, Says Neelkanth Mishra

Neelkanth Mishra: So, there is a growth concern. Most high-frequency indicators have slowed. We've seen sharp pickup in earnings cuts. Initially, these cuts were only in FY25, in the last couple of weeks, we have seen FY26 earnings start getting cut as well. So investors and analysts are starting to get worried.

The indicators that we track, there's not yet a very strong sign of recovery, but I think there is enough for us to be slightly optimistic. Our view is that this slowdown is cyclical, and that incrementally now momentum indicators should be improving whether or not we get back to the growth trajectory that we had, the growth rate that we had in January-February this year is something that is less sure right now, but let's see how they can revive.

I will just add an additional point over and above the government spending. I think it is also about the monetary side of things. I know that the MPCs' hands are tied because of headline inflation, but on the quantity side, I think some of the other measures taken have also contributed to some of the slowdown. But you know, those measures are also easing. So starting July, overnight, liquidity was in surplus. In the last couple of fortnights, we have seen that is now starting to drive up deposit growth. So as you know, deposits are a macro variable, and they are starting to improve. So with both fiscal and monetary, the unintended tightening that happened started to ease. It is reasonable to expect that by Jan-Feb, some of the high frequency indicators will start improving as well. 

Neelkanth Mishra: So, let's put it on two different things, basically two different variables. The first is what is the global price to earnings, and second is what is India's premium to that. So let's start with the global price to earnings. Now global price to earnings are likely to possibly come under pressure because of all the macroeconomic uncertainty. So for example, if the Trump policies were to get implemented, you will see a fiscal deficit over the next 10 years. So let's say the debt over the next 10 years, cumulative deficit over the next 10 years for the U.S will be higher by $7-8 billion. So that is what some of the estimates are suggesting.

Now, given what this entails in terms of bond yields, because if this level of excessive borrowing happens, then bond yields will go up, and that itself could be a disciplining force for the U.S. It's quite possible that it goes up, say, by $3-4 trillion, not $7 trillion, but $3-4 trillion and given that this itself means that it's very unlikely that this will be able to be paid back. The only way to adjust for that would be for inflation to go up, and that will mean maybe one percentage point rise in inflation expectations.

If you look at the tariffs now, there are all kinds of estimates. There are some people who estimate that the consumer price index will go up by 1.8% in the U.S. Others believe it would be 2.5%. Remember that a very large part of U.S consumption is Services, which doesn't get affected directly. Now that itself over 10 years, would mean 20-25 basis points of higher inflation expectations. Now, if this is the case, and you have an increase in the term premium, because you need to have much higher yields to attract new buyers for government bonds, the U.S cost of the higher-for-longer story in the U.S now gets very cemented.

We will start getting clarity on this. So, we have seen an inflation expectation increase in the U.S by, say, maybe 25-30, basis points. But I don't think the markets are clear on where things will settle by maybe February-March, once the new President and his team are in place, we will start to see some clarity. But I think uncertainty on the macroeconomic side will remain elevated. So, this means that global price to earnings is likely to also not see a significant increase.

Now, when we come to the Indian story, India's premium had expanded to, you know, in between for a while, 45-50% of the world. It has, over the last several months, been corrected. Now we are at about 15-17% which is, I think, a reasonable level of premium to have. Can this premium expand if we see a growth acceleration? Possibly, because what happens when growth estimates are being upgraded, which is what started in Jan '23 and lasted till about, I would say, April-May of this year, was that the economy was continuously surprising on the upside. When those surprises end, it is reasonable to expect that the P/E multiple, or the premium, then starts to come off, which is what it has done as you start to see cuts happen. So now we are starting to see GDP estimates getting slashed, by consensus, then the P/E premium starts to come off.

I think going forward if the growth acceleration starts to re-emerge by Jan-Feb, it is reasonable to expect that the premium, you know, from 15% could actually maybe go up to 20-25%. I mean, I'm not a big believer in just linking tightly the economy and the markets, but those broad frameworks, I think, should still work. Remember also that the FII outflows, what we saw in October, and they continued in November, were nearly two times the pace at which the domestic inflows were happening. So when this level of outflow happens, obviously there will be a pressure on price to earnings.

Now the question to ask is, are FIIs done selling? From what we have seen in the data, a large part of this selling of India is actually EM-level selling. Given that the China stimulus itself has not been that exciting and higher U.S rates, generally means a stronger dollar, which is actually generally not so good for emerging markets. So, I don't think we are done with the FII selling yet, but whenever it gets done, it is reasonable to expect it to bounce in the Indian markets as well.

Neelkanth Mishra: You see, the FII ownership of India was rising steadily after 2003-4, right? So on BSE 500 ownership rose dramatically, about 4-5% to 22-23% at the peak. I think the technical limit on where it kind of bottoms up, I mean, I think what matters is that our EMs as an asset class is going to get inflows. Remember that only 10-15% of FII ownership in India is through India dedicated funds. Very large part comes through EM funds, some through Asia Funds, some through Global funds. Therefore, if EMs or Asia are looking slightly less attractive because the U.S 10-year rates are up, or the expectations of Fed rate cuts are being pushed out, and therefore the likelihood that, say, Indonesia or Malaysia also will not have that much room to cut rates.

In general, if you're getting 4.5% on the U.S government bonds, then why take the risk of emerging markets? Now, those concerns and questions are still very much alive and therefore, the long monologue I had on why the U.S rates become so important. If the uncertainty on the U.S rates remains elevated and the U.S rates are not going to really come off, then I mean, unless there's a massive positive growth surprise from one of the large EMs, there is very unlikely that EMs will start getting inflows, and which is why, if you actually see them as percentage of market cap, see, remember that $10 billion in a month seems like a lot of money, which it is, but compared to the percentage of market cap, this is not that exceptional.

So, a month of point 2% of market cap selling by FIIs has happened several times in the last decade itself, and then the last few times it happened, actually the market declined a lot more because the domestic weren't buying or the domestic didn't have that kind of heft. But if you look at three-month or 12-month flows, they are completely unexceptional, in the sense that they are not at levels where you see a technical rebound.

Generally, if you plot a 15-year history of 12-month flows as a percentage of market cap, the current situation is very unexceptional. So I won't be surprised if the FII selling, which has continued through November, lasts through all of November. So there's no technical limit on what the ownership level is. I don't think anyone is looking at those. I would rather look at the flows as a percentage of market cap, where they kind of bottomed out in the past, or when the U.S fiscal clarity comes, and say, the new U.S government, gives some signals on what their actual fiscal plans are and what level of deficits are they okay with.

Frankly, given all the other political issues that matter to them, on tariffs, on immigration, on, you know, the promise of tax cuts that are very important, all promises, it is very unlikely that fiscal deficits or clarity on that is going to emerge. So therefore, 10-year bond rates are not going to come off. So, EM outflows, and therefore India outflows can last for another several weeks.