Can’t take equity capital flows for granted even if Fed cuts rates: Neelkanth Mishra

Indian equities are perhaps as expensive against the U.S. 10-year yield as they've ever been, according to Mishra. And the way to adjust for that or the way this can be corrected is if the US 10-year yield falls substantially from current levels

The stock markets have been rallying on optimism that foreign portfolio flows will flood Indian equity markets if the Federal Reserve starts to cut interest rates, but investors should not take this as a given because global liquidity is set to contract posing a key challenge to emerging market (EM) fund flows, Neelkanth Mishra, chief economist at Axis Bank and global head of research Axis Capital said.

“I would not extrapolate the flows that happened in the month of December, which was a bit of a surprise. It came because the Fed's pivot turned out to be surprising to people. And that triggered some inflows, but I think it would be a mistake to extrapolate it over 12 months.” Mishra said.

In December, FIIs bought equities worth Rs 31,959.78 crore in the cash market, outpacing DII buying of Rs 12,942 crore.

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Misha’s view rests on his prognosis that global liquidity is set to contract even as US rates rise again owing to fiscal unsustainability. The US fiscal deficit rose from $1 trillion to $2 trillion in FY23 because of an accounting adjustment and shortfall in income tax collections.

This calendar the US fiscal deficit will close at 8.5- 9 percent of GDP, thus, the US yield will start to face an upwards risk not because of monetary factors, but fiscal reasons.

“I think the pension funds and asset allocators will start questioning if we are getting 4.5 percent on US Treasuries, why are we in any of the emerging markets,” he said.  EM funds could thus see outflows.

“Even though India may be, and will be, doing very well economically, the fact is that a lot of the flows that come to India come through Asia funds, EM funds, global funds... if those funds are seeing challenges, either because of China or some other emerging market that gets into stress, I think the flows to India will be affected.”

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On valuations, Indian equities are perhaps as expensive against the U.S. 10-year yield as they've ever been, according to Mishra. And the way to adjust for that or the way this can be corrected is if the US 10-year yield falls substantially from current levels.

“If they go back to 2.5-3 percent, then you can say that yes, it corrected. For now, there is a yield gap (for global investors), because there is a risk-free rate (US 10-year) and then you are adding on country risk and asset class risk like equities. So, there is that distortion,” he said.

To the question if Indian investors should be concerned about the return math for foreign investors, even though, structurally domestic flows contribute about $30 to $35 billion annually, Mishra said, “We cannot take them (foreign investors) trivially.”

Foreign funds own about 18 percent of the BSE 500, and they account for about 35 percent of the free float. “It’s because of them that you're actually seeing that there seems to be some valuation discipline in the large-caps,” Mishra said. “In the small caps and mid-caps in India, there are a lot of flaws that are now becoming visible," he said.

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More importantly, he noted that even if one were to look at Indian government bond yield i. e the 10-year bond yield as the discount rate, one would find that the equity risk premium is too low. “For a while, it was actually negative. So even compared to Indian government bonds, Indian equities are expensive.” Mishra said.

Mishra, however, said that the correction in PE (price-to-earnings) multiples is not going to happen suddenly, because it is about the market as a whole.

“The market has millions of nodes, basically millions of people, millions of entities which are trading and dynamically pricing in assets. So as that happens, I think the collective appreciation of the changed environment is something that takes a while, and it could take several years. But it is prudent that if we are thinking about an exit from a stock or say, from even the Nifty, say three to five years from now, we shouldn’t be modeling in lower rates," he said.