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. 

Neelkanth Mishra: So, Tech as a space, my only discomfort with the sector is its valuation. So all that you're saying, and I think those are all facts, that Tech, you know, it's a very low volatility sector, so if it doesn't grow at 8% grows at 4% maybe four will go to two. But there is a certain certainty. It's very unlike, say, Metals or oil or any other commodity sectors where things can be quite volatile.

Secondly, it is very low capital intensity, generates a lot of cash flow, generally, professionally managed. If they're sitting on surplus cash, they're very happy rolling it out. They don't want to retain it and make some stupid acquisitions. So they're generally very disciplined with capital allocation as well. So it's a good sector. The challenge I see is that it is very expensive, and so therefore, a lot of what you're saying, in fact, you know the lack of clarity, or reduction in the lack of clarity, all those things will happen.

But remember that there are other levels of uncertainty that people are going through. I mean, if large tech firms are publicly saying that AI is generating 25% of their code, it is. I mean, there are strategic uncertainties emerging. While I think Indian firms have gone through significant challenges in the past 25 years, from Y2K to Dot Com, the bust, the transition to mobile, transition to cloud, and every time, they have ended up gaining from them. So I'm quite confident that over time, I think the Indian I.T. firms should also learn how to cope with AI.

But you know, will this mean that the productivity per employee goes up dramatically, that the margins improve, but the top line does not which companies will be able to make that transition? Do we have clarity on which company and what kind of business exposure? I think all of these uncertainties make me very uncomfortable with the level, the price to earn its multiples that exist and sequentially, unless the U.S economy starts to improve a lot, I doubt that we are going to see a sharp rebound in the revenue expectations for these companies. So we are underweight on them.

This call hasn't worked, because the market in the last four-five months is trying to chase, in fact, before the results season, after that it's worked nicely. But between May and September, as domestic high frequency indicators were weakening, the markets were trying to get into the defensive sector, so Staples, I.T. outperformed, but that was just people trying to hide. I don't think there's any significant fundamental improvement that is likely.

Neelkanth Mishra: I am not allowed to comment on specific companies. 

Neelkanth Mishra: So, what happens occasionally is that because one of the big challenges for Indian corporates today is that they need to find investment options. So one of the very important macroeconomic trends that have emerged is that our current account deficit is now maybe 1% or less than that. This is when the general government deficit is 7-8%, maybe 7.5-8% and household savings are still kind of continuing, but even though, you know, on the net basis, they were slightly lower.

Now in this case, who is the beneficiary, who is getting more saving? It is the corporates, because there are three entities, like government, corporate, households, and the government is not net saving. Households are not saving that much and overall, this dissaving is only very small, which means that corporates are saving a lot. So that you can see the data. So the BSE 200 operating cash flows have grown at like 22% CAGR between FY19 and FY24 investing cash flows which are also growing. So, we remain convinced that the investment cycle will remain positive, and we should see some good momentum pick up in six-nine months.

The investing cash flows as the percentage of operating cash flows, which was 140% in 2012 and '14 has now fallen to 70%. So, all of these groups now need to figure out where to invest. Some of them could be diversifying into jewellery. Some would be diversifying into Paints. Some are going abroad and some are, you know, buying stakes in Auto companies.

So you will see this phase of diversification, and therefore, the competitive intensity in some of these sectors is actually going to change, because you are going to see new companies coming in, and new competitive realignment happening, and that uncertainty means lower price to earnings. So those are also challenges that investors should be wary of.

Neelkanth Mishra: That is my expectation. If you think about macro issues, which are fiscal and monetary. It's almost like none of those oxygen bubbles that keep happening in fish tanks, whenever power goes off and the bubbles slow down, the fish starts swinging slowly and because oxygen levels are starting to deplete, and then, you know, power comes back, those bubbles restart when oxygen is back. So many of these macro changes that occur when you see an unintended fiscal contraction, an unintended monetary tightening on the quantitative side, it's very hard to explain, one on one as to what's really happening, but it's all a macro phenomenon, and the moment the flows start showing up.

I would say that incrementally, the slowdown is not worsening, because from May onwards, it was very clear that things were slowing down, and the momentum was very negative. Now I think at the margin, things may actually be bottoming out. It's too early to say there are only a few indicators which suggest that, but we are tracking them, and it is reasonable to expect that as fiscal monetary tightening ends and some relaxation starts, that demand will go up. Now, that demand could show up in Real Estate demand, that could show up in demand for Cars, it could show demand for Consumption. Items, Investment items. So any one of those are just outcomes, I mean they're not really input variables.