This market may be a 'slow moving train wreck'

Indranil Mrukherjee | AFP | Getty Images

The downward spiral in the Indian rupee poses a significant threat to the country's equity market, according to one strategist, who warns that continued weakness in the currency could prompt foreign investors to flee domestic stocks.

The weak rupee has depreciated 10.8 percent against the U.S. dollar this year, making investment returns less attractive for foreign investors, who are a major driving force in the market.

"When an emerging market currency does not respond positively to policy liquidity tightening, the market is in deep trouble. Therefore, further price weakness in the currency could plausibly drive further weakness in the equity market," said Nicholas Ferres, investment director, global asset allocation at Eastspring Investments, referring to the Reserve Bank of India's recent measures to tighten liquidity in order to make it more difficult to speculate against the currency.

(Read more: Is India's rupee back in the danger zone?)

"Indian equities may be a slow moving train wreck that is close to derailment," he said.

Despite growing risks to the outlook for Indian stocks, they have held up better than other emerging market peers. The benchmark Sensex index has declined 3.6 percent year-to-date, compared with the Shanghai Composite, for example, which has lost 9.2 percent.

This is partly because Indian equities have seen very little foreign selling compared to other developing markets in the region, said strategists. Three billion dollars has exited the country's stock markets in the recent months, compared with a total $16 billion of inflows this year, according to data from Goldman Sachs.

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But with Indian equities trading at 14.1 forward times earnings and 2.5 times book value, Ferres says they are not cheap from a global perspective, and this could force foreign investors to rethink whether it makes sense to be in the market.

"That is the same valuation as U.S. equities with similar levels of profitability, but higher inflation, gearing and inferior corporate governance," he said.

"Foreign investors who have paid up for the superior growth might simply panic. Under that scenario we may get a proper episode in the equity market," he added.

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U.S. investment bank Goldman Sachs last week downgraded its rating on Indian equities to underweight from neutral citing, concerns around the deteriorating macroeconomic environment, weakening earnings and the risk of foreign selling.

"While stretched positions in rest of the region look largely cleared, foreign positioning still looks extended in Indian equities," the bank said in a report last week.

"Funds have been overweight India for past couple of years, they haven't reduced their allocations meaningfully so far this year despite the poor macro environment. We see a rising risk of funds paring their India allocations if macro conditions continue to deteriorate," it added.