How Long Will The Liquidity Party Last, And What Can Break It?

"The main driver has been a deluge of domestic liquidity, driven by the financialisation of savings (direct and indirect participation) and formalisation (pension fund allocations)," says a report by Macquarie named The India Diviner. 

The punchbowl of equities is overflowing. From 2024 until now, mutual fund net inflows were $3.1 billion per month. This is twice as much as the $1.7 billion seen in 2022 and 2023.

“Over the past few years, both the quantum and stickiness of SIP flows have positively surprised market expectations,” Macquarie says. This is despite record-high redemptions seen in July 2024 to the tune of $4.8 billion. 

So far, since April 2022, as much as $70 billion has made its way into the equity markets via mutual funds. 

There is a sharp increase in direct participation in the markets, too. As many as 66 million retail investors have entered the markets since 2020. This money inflow, which has shown resilience and investors’ intent to chase buy-on-dips is lowering the risks associated with a market as highly valued as India.

Indian equity markets are trading at 21 times the price-to-earnings (PE) ratio, while the rest of the world is trading at 14.5 times its PE. Even emerging markets are trading at 10 times, while the US is now trading at 17 times.

Most analysts, including Motilal Oswal, believe that India’s growth runway is so wide that its PE valuations are justified. “Compared to its EM peers, India has been considered expensive over the last 20 years. An anomaly in a data set can be overlooked, but when consistent, it becomes the norm,” Motilal Oswal said in its strategy report.

But Macquarie believes that while India offers a long runway for growth with mega-trends in its favour, its current valuations are not justified. Especially since fatigue is setting into the earnings expectations of the top 300 stocks in India.

"From a bottom-up lens, however, we see limited evidence to support earnings upgrades across sectors—i.e., the favourable thematics are already more than captured in consensus estimates, we believe," the report adds. However, it also notes that strong liquidity equals shrinking risk premiums, allowing the markets to sustain valuations at staggering heights. 

The 'equity suppliers' are lapping up the high liquidity in the market. Apart from new companies going public, preferential rights, QIPs, rights issues, and FPOs have been going up too.

"How long could this liquidity party continue? While promoter selling suggests it’s perhaps time to take profit, when viewed through the lens of household financial savings allocation, the punchbowl continues to fill," says Macquarie.

Household savings itself in India saw a modest growth of 8% compounded annual growth rate between 2015 and 2023. But the chunk of allocation itself has grown—as much as 30% of it is making its way to capital markets.

"In our minds, incrementally, the story is less about a penetration increase and more about the relatively older cohort of individuals (with naturally higher savings) allocating a stronger share of their savings to capital markets and away from physical assets like gold and real estate," says Macquarie. 

Added to that, savings allocation to provident and pension funds and insurance have also been expanding. As much as 10% of the former and around 20% of the latter make their way to the capital markets. 

How will the trend play out in the next three to five years? Will the love for financial savings hold on? Here, Macquarie has two scenarios. If all else is equal, assuming 10% nominal GDP growth and no change to macro ratios of the savings mix, it can translate to over $120 billion in flows to equity markets.

If the financialisation of the savings trend increases by 500 basis points, it could result in as much as $180 billion flowing into equity funds by March 2028.

“As such, our final conclusion is that regardless of headline elevated PE multiples, this local liquidity dynamic, with a long runway, explains why we believe equity prices in India will continue to be bid up. What could break this? We closely watch for any changes in household disposable incomes, savings, leverage, tax, and regulations,” Macquarie said.