The worst may be over for emerging markets

The Bloomberg Emerging Markets Capital Flow Proxy Index shows that capital flows in the EMs remained subdued in CY22, and lower than the historical average. “Flow movements were nonetheless asynchronous as economies with wide external imbalances witnessed larger outflows than those that run low-risk balances, including commodity players namely Indonesia, Brazil, etc,” said Radhika Rao, senior economist and executive director at DBS Bank, Singapore.

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India was no exception to this trend. The country’s equity market saw outflows worth $17.13 billion in CY22, showed NSE data. FIIs were net sellers in India’s debt market too. Heavy lifting by domestic institutional investors (DIIs) saved the day for India.

Hereon, a lot depends on the US Federal Reserve’s monetary policy stance, but another key event to watch out for is the reopening of China. “Our analysis of historical flows suggests India doesn’t compete for FPI flows with China. In a risk-on scenario, hence, any incremental flow to China through the EM basket would imply inflows to India markets,” said Amish Shah, head, India equity strategy at BofA Securities. Further, India’s overweight positioning of foreign institutional investors currently stands at multi-year lows of 0.14% versus peak of 1.2% in 2015, he said.

Even so, India’s relatively expensive valuations may act as a deterrent. The MSCI India index is trading at a one-year forward price-to-earnings multiple of 19.53x, showed Bloomberg data.

What’s more, if India Inc.’s earnings do not live up to the Street’s expectations, then this valuation multiple will add to the discomfort. In Q3FY23, India Inc.’s revenue growth is likely to moderate sequentially. This is even as operating margins, which have been under pressure owing to the cost inflation pressures, may start improving. While analysts do not anticipate steep downgrades for FY24 consensus Nifty earnings per share estimates, upgrades may happen gradually and selectively.

As things stand, the US Fed is expected to maintain its hawkish stance though the quantum of rate hikes would reduce. This should help contain the strength of US dollar, a safe haven asset, which generally augurs well for EM assets.

“EMs have suffered quite a bit in CY22 in terms of foreign fund outflows, so we think that the worst may be over, simply because the majority of quantitative tightening is behind us,” said Vinod Karki, head of strategy at ICICI Securities Ltd.

Secondly, the International Monetary Fund has projected EM economies to show relatively better economic growth than developed markets in CY23, which offers some relief. That, along with China’s reopening should help the EM basket garner increased FII attention. “However, China may see higher allocation than India because it had borne the brunt of EM selloff last year and has turned relatively cheap on valuations,” Karki added.

That said, everything is not hunky-dory for EMs. With elevated global uncertainty, EMs could see renewed deterioration in their fiscal slippages and wider trade deficits, amid moderating economic growth.

“If Fed pivot (a point at which the US Fed reverses its existing monetary policy stance) drags beyond H2CY23 we could see risk-off trade which could lead further outflows from EM equities,” cautioned Shah of BofA Securities.

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