How Fed action gave Indian stocks a leg up

The movement of the Indian stock market was quite difficult to comprehend in 2019. There were a host of factors exerting downward pressure on stocks — a decelerating economy, slowdown in consumption, woeful corporate earnings and tight liquidity, to name a few. But despite these odds, the bellwethers — the Sensex and the Nifty 50 — continued to hit record highs and have gained over 10 per cent since the beginning of this calendar.

This surprisingly steady performance took place even as domestic investors turned sceptical of the narrow rally in stocks. This is evident from the tepid flows in to mutual funds. Retail investors, too, have been singed while dabbling in small- and mid-cap stocks.

While the above has been well chronicled, one factor that has escaped attention is the strong inflow from foreign institutional investors in 2019.

With greater focus on the foreign portfolio outflows in July and August, the fact that FPI inflow this year is the highest since 2014 has gone unnoticed.

This could largely be due to the change in stance of the US Federal Reserve. It halted its balance sheet tightening in August this year and has once again begun injecting liquidity into the US economy since October. The Fed’s monetary easing in the past has coincided with copious inflows into Indian equity market in the past, post the global financial crisis. The same sequence seems to be playing now as well.

FPIs buying Indian stocks

Foreign portfolio investors net purchased ₹92,862 crore up to December 12, 2019; far higher than the inflow of ₹13,881 crore in 2018 and ₹53,221 crore in 2017.

These investors had begun the year on a cautious note with net outflow of ₹4,262 crore in January. But the general elections in May, and the possibility of the NDA returning to power for a second term seems to have spurred the FPIs to net purchase ₹80,314 crore of Indian stocks between February and May 2019.

Despite the pull-out in July and August following the escalation of the global trade war and domestic growth concerns, these inflows returned strongly in October and November, to end the year on a record high.

On the other hand, mutual fund purchases, that had been more than twice the purchases of FPIs in the equity market between 2015 and 2018, dwindled to ₹55,413 crore in 2019.

What the Fed did

The volte face in FPI flows in the last quarter of this year can be traced to the actions of the Federal Reserve. The Fed’s asset purchase programme since 2009 had resulted in bloating its balance sheet from $865 billion in 2007 to $4.5 trillion by the end of 2014.

It had also cut the Fed Fund rate from 5.25 per cent in June 2006 to 0.25 per cent in December 2008, thus spurring the dollar carry trade that had caused an increase in asset prices across the globe since 2009. Over one-third of FPI flows into India originate from the US.

But the Fed was also the first and the only central bank to begin normalising its monetary policy; probably helped by a relatively better growth in the US economy. It began hiking interest rates gradually and also stopped reinvesting a portion of the securities that were purchased as part of its quantitative easing programme.

However given the global conditions and the nebulous recovery in the US, in the March 2019 meeting, the FOMC announced plans to slow the pace of monetary tightening. It also stated that once reserve balances had declined to an appropriate level, the FOMC would begin increasing its securities holdings.

At its July 2019 meeting, the Committee decided to conclude the reduction of its securities holdings in August, two months earlier than previously indicated.

In October 2019, the FOMC released a statement that outlined plans to purchase treasury bills at least into the second quarter of 2020 in order to maintain an ample supply of reserve balances at or above the level that prevailed in early September 2019.

The Fed’s actions were partly prompted by the short-term disruption caused by the US repo market this September.

The fallout of this episode has been to make the Fed more cautious about the level of reserves it maintains and the liquidity in the market.

But the decision to inject liquidity till the first half of 2020 is good news for the Indian stock market. The link between FPI flows into India and the quantitative easing by the Federal Reserve is pretty well established.

There were copious inflows amounting to ₹5,51,992 crore between 2009 and 2014 as the Fed did a series of quantitative easing programmes to boost the US economy and maintained the Fed Funds rate close to zero.

But inflows had contracted with the beginning of monetary tightening by the Fed in 2015.

Other reasons

An interesting point worth noting is that not all emerging markets received foreign portfolio flows in 2019.

While China has been the biggest beneficiary of FPI flows, India received the second highest investments. Most other EMs witnessed outflows.

This seems to show that despite the ongoing troubles in the Indian economy, FPIs are confident about the long-term prospects of Indian equities.

The stellar performance of the Indian large-cap stocks could also be attracting FPI flows. A World Economic Organization report shows that foreign funds flows into a country is influenced by the performance of its equity market.

The relatively stable rupee could be another reason that FPIs are willing to pump more money into India as a stronger rupee boosts their dollar returns.

This increased flows from FPIs is however not too good for the equity market stability. The market indices have a tendency to decline over 20 per cent from the peaks due to global headwinds, when FPIs dominate trading.

The relatively shallow corrections witnessed since 2009 were largely due to domestic institutions controlling market liquidity. As the tide turns again, there could be interesting times ahead for Indian equity investors.