Indian Market Hits New Highs Despite Weak Q1 Earnings: Analyst Warns FIIs, Global Market Rally May Not Last

Over the past three weeks, the Indian stock market has benefited from a global rally and strong domestic investments. Despite less encouraging domestic economic data this month, robust inflows from Domestic Institutional Investors (DIIs) and retail investors have helped offset the selling by Foreign Institutional Investors (FIIs). This has allowed the market to reach new highs.

However, corporate earnings growth has been weak, and economic indicators, along with the Reserve Bank of India’s policy decisions, have only met or slightly missed expectations. Despite these challenges, positive global sentiment, including hopes for rate cuts, has increased interest in the equity market. Another boost to domestic sentiment is the drop in crude oil prices, which are now below $80 per barrel.

Global Market Recovery

Globally, stock markets have recovered about 75% of the losses from the July 2024 sell-off. Indices like Nifty50, Dow Jones, and DAX have hit new highs. However, it’s too early to declare this as a sign of sustained growth. Continued net selling by FIIs in markets such as Japan, South Korea, and Taiwan, which were among the hardest hit, indicates ongoing uncertainty. This recent rally might be a short-term rebound, possibly driven by the end of yen ‘carry trade’ selling after Japan’s stock market corrected by 25%, creating a brief buying opportunity.

Foreign Institutional Investors’ (FIIs) Selling Pressure

Recent reports show that FIIs continue to be net sellers in Japan. Domestic investors are also cautious, with institutional players being the exception. The Bank of Japan (BoJ) has offered support to financial markets by signaling no further rate hikes and aiming for stability in financial and currency markets. Similar trends have been seen in other global markets. However, the key question remains: Is this recovery sustainable? It’s likely that this rally is a short-term bounce back after the market was oversold.

The issues that caused the sell-off remain unresolved and could reappear in the medium term, particularly with the yen’s appreciation and rising Japanese interest rates. Many economists predict that the BoJ will raise rates in 2025 to tackle inflation and control the yen carry trade, which has surpassed the central bank’s limits. This could reduce yen-denominated and arbitrage trades, which have been a significant source of global liquidity in recent years.

Interest Rate Changes and Their Impact

Moreover, the global market has been optimistic about a shift in interest rates from a rising to a falling cycle. While this is good for the stock market in the long term, the extent and timing of these rate cuts need to be carefully considered. Currently, US Federal Reserve rates are at a 20-year high of 5.5%. A 25 basis point cut by the Fed in September will not immediately offset the negative effects of high interest rates on the global economy.

Long-Term Outlook

Expected Rate Cuts and Bond Yields

In the long term, economists expect the Fed to reduce rates to around 3.75% within the next year, which is still above the long-term average. Bond yields are also expected to stay above the long-term average, which could slow down spending and consumption. At the same time, central banks worldwide are reducing their balance sheets by cutting back on bond purchases or selling bonds, which will reduce liquidity in the financial sector. This reduction in liquidity is likely to impact market yields and slow economic growth due to lower spending. Additionally, with inflation and fiscal deficits on the rise, the ability of market yields to decrease significantly in the short to medium term is limited.

Investment Strategy Recommendations

Given these conditions, adopting a cautious approach to the current market rally in the short term is wise. This caution is evident in the market’s behavior, with significant shifts between sectors and a move from growth to value stocks. Over the past month, the top-performing sectors have been Pharma, Consumer, and IT, while weaker sectors include new growth areas like Public Sector Banks (PSUB) and Realty. We expect this cautious investment pattern to continue in the short to medium term.

Vinod Nair is the Head of Research at Geojit Financial Services.