Despite gloomy economic news out of India in recent months, foreign investors have continued to bet on Indian stocks with the benchmark Sensex rising more than 12 percent since the start of the year.
Analysts tell CNBC the momentum is likely to continue with stocks set to gain double-digits over the next year as a softening interest rate environment, low valuations and long-term gross domestic product (GDP) growth potential will continue to attract inflows.
After falling almost 25 percent last year, the Sensex has seen huge foreign institutional investor flows in the first quarter of the year. According to Reuters, overseas investors have put on average $3 billion a month in Indian equities and bonds in the first quarter of 2012.
Foreign Institutional Investors’ ownership in the top 75 Indian companies rose to 20.4 percent, a five-quarter high, in the first quarter of this year, according to a Morgan Stanley report.
Rajeev Malik, Senior Economist at brokerage CLSA says, “Risk Capital is still in large supply. People are willing to take large risk,” and the Indian markets are benefiting from this risk-on play.
Even the recent downgrade of India’s credit rating outlook to negative by Standard & Poor’s hasn’t had a big impact on investor sentiment, with the Sensex rising over the past week.
“There are limited implications for the markets right now. It (the downgrade) is good for the government; it is pushing them to do something. The stock market has not reacted to it,” Ridham Desai, Managing Director, Morgan Stanley, Research, told CNBC.
In a recent report, HSBC forecasts the Sensex will rise to 19,300 by the year-end, an upside of more than 10 percent from current levels. Morgan Stanley expects a 20 percent rise in the benchmark index over the next 12 months.
According to Desai, broad market valuations have rarely been cheaper at 1.1 times price to book, making Indian equities very attractive.
Besides low valuations, expectations of further rate cutsare also a driving factor for the stock market, says HSBC, which forecasts the Reserve Bank of India will cut interest rates by another 25 basis points this fiscal year after the 50 basis point cut in April.
Downside Risks Persist
But the Indian stock rally could fizzle out if the risk appetite wanes, warns Malik. A falling currency , a huge fiscal deficit and a lack of government will to create a more favorable investment environment could all catch up with the stock market.
“The Indian government needs to do more to attract foreign direct investment and not be dependent on risk capital flows alone,” says Malik.
Foreign investors have raised concerns on two recent provisions to tax indirect investments and fight tax evasion, saying it makes India less attractive as an investment destination.
After a surge of foreign inflows in the first quarter, foreigners were net sellers of Indian equities and bonds at $403 million in April, according to Reuters.
Nick de Boursac CEO of Asia Securities Industry & Financial Markets Association, (ASIFMA), told CNBC's “Cash Flow, “If you look at the flows, they're already stopped. In other words, they've not stopped to zero but you have companies pulling out and you find the volume of flows has significantly dropped.”