What’s behind the recent volatility in Indian equity markets?

In the past few years, Indian equity markets have been immune to volatility, given strong macro, robust earnings growth and strong domestic flows. Volatility appears to be back in Indian equities, with benchmark indices down 8% in October. The broader market correction has been steeper, and over 175 stocks in NSE 500 are down more than 25% from recent peaks.

This swing in the market has come about despite strong inflows into domestic MFs. Domestic MFs witnessed ₹344 bn ($4 bn) of inflows in September, taking inflows in H1 FY25 to $30 bn. SIP flows continue to grow - reaching a new high of ₹245 bn ($2.9 bn) in September, and this trend has continued in October. This is reflected in MFs' net buying of $9 bn month-to-date.

This turn in momentum is attributed to foreign selling - an unprecedented $10 bn in October. With this, FII flows in FY25 are $150 mn. One can ascribe a few reasons for the swing in foreign flows:

• US 10-year yields are up 65 bps since the mid-September.

• Dollar index has strengthened by 3.5%.

• Policy changes that have led to shift in flows to Chinese and Japanese markets.

Strong domestic flows proved to be an adequate counterfoil for foreign flows all through FY22 and FY23. In FY22, FII outflows stood at $18.5 bn while FY23 saw $5 bn of outflows. However, MFs witnessing $53 bn of inflows were able to absorb these outflows and markets registered 18% up move in these two years despite the foreign selling.

Accelerating pace of equity supply is the key reason domestic equity markets are again developing a vulnerability to the volatility in foreign flows. Q2 saw supply increasing to $21 bn compared to $15 bn in Q1 FY25. This comprised of $4 bn of IPOs, $6 bn of QIPs, and $11 bn of secondary stake sales from PE and promoters. These outstripped the $18 bn inflow into equity MFs during the quarter. However, as FPI flows were positive at $11.6 bn in the quarter, the upward market trajectory sustained.

Supply of equity in the form of IPOs and stake sale since FY24 has been 1.5x the net inflow into MFs. Impact of this on the market direction was masked as FII flows over the last 18 months (April 2023-Sep 2024) were positive at over $35 bn. These aided in absorbing the increased supply. Over 40% of the IPOs/QIPs raised during this period were subscribed by foreign inflows.

IPO pipeline for H2 is nearly 3x the amount raised in H1, with 91 companies looking to list and in aggregate raise $17 bn. Another 70 listed companies in recent weeks have taken board approvals to raise in aggregate $16 bn of equity through QIPs. Secondary stake sales from promoters and PE are also only likely to grow larger, given the expiring lock-ins and elevated trading multiples in the market.

Assuming secondary sales (by promoters and PEs) at $22 bn in H2 stay similar to what we have seen in the first half, the total supply will rise to $55 bn in the second half of the year, or about 2.5x estimated inflows in MFs. Ensuring that equity supply will overwhelm domestic fund flows, and market direction will again be subject to vagaries of foreign flows.

This magnitude of equity raises the possibility of the private investment cycle gathering pace, and unlike past cycles, this would be more equity-funded rather than debt-fuelled. Of the $39 bn raised by corporates (IPOs/QIPs) in the past 18 months, $25 bn was primary capital. The H2 FY25 pipeline indicates another $24 bn of investible capital being potentially available for capex, acquisitions and other purposes.

The breadth of companies looking for capital is wide. Power sector ($4.7 bn) and real estate ($4.1 bn) stand out with largest capital raises each planned for this year. Services companies (IT, logistics) at $2.3 bn, retail (Qcom, FMCG) at $2.9 bn, healthcare at $2.3 bn, metals at $2.2 bn, and auto at $3.1 bn are other sectors witnessing material capital raises.

Judicious use of this capital by corporates would be a key determinant for sustaining the earnings growth momentum as easy capital availability can tempt companies into low-return capex, unrelated diversifications and expensive acquisitions.