What are the FIIs doing?

Cheap valuations and a strong shot of liquidity both had a hand in the Sensex staging a breathtaking 81 per cent rally since March. Of the two, the role played by the gush of liquidity cannot be overemphasised as foreign institutional investors (FIIs) and mutual funds together pumped in over Rs 31,160 crore into equities.

But with the trend of FII buying turning into selling over the past couple of weeks, are we heading for a dry patch yet again?

While it is India Inc’s growth prospects that may decide the market’s long-term outlook, it is liquidity that will call the shots in the near term. We look into the trends in the money trail and what they portend.
FIIs in re-balancing mode

After piloting the rally from April to May, FIIs turned net sellers in Indian stocks over the last two weeks, pulling out a total of over Rs 3,670 crore (or $757 million).

In addition to selling in the cash market, they have also significantly reduced their exposure in derivatives. So are FIIs then turning negative on India?

A look at the recent fund flow data released by fund tracker EPFR Global suggests fund flows have been interrupted, calling for caution; but it is early days yet to call it a reversal.

In its latest release for the week ended June 24, EPFR reported investors pulling out a net $1.87 billion out of funds focussed on Asia excluding Japan, Latin America, Europe Middle East Africa and the diversified Global Emerging Markets Equity Funds, driven by doubts about the timing of a recovery in the global economy.

This is the first instance of outflows from emerging markets since March when the rally began. It contrasts with the average inflows of $3.2 billion into dedicated emerging market equity funds in the weeks from April 30 to June 10, when money flowing out of US money market funds had bypassed developed markets only to pour into emerging market equity funds.

The India Equity Funds too now report outflows, after taking in money until last week. While a part of the recent domestic selling could be attributed to the not-so-cheap valuations of equities and the upcoming Union Budget, an event risk some of them may like to steer clear of, recent outflows also suggest a moderation in risk appetite, a key to fund flows into stock funds in general and emerging markets in particular.

The June 24 week brought signs that Money Market and US Bond Funds reported fresh inflows helped partly by interest rate hike expectations. The two fund groups absorbed $25.9 billion and $1.72 billion, respectively, during the week, showing renewed preference for a safe haven.

However, it cannot yet be concluded that this marks the end of inflows into our markets. For one, despite the flight of capital towards safer options, dedicated BRICs (Brazil, Russia, India and China) Equity Funds continued to attract inflows and extended their winning run last week too.

There are other indicators of global investors remaining keen on India. The number of FIIs and sub-accounts registered with SEBI has been on the rise. From 1,594 FIIs and 4,872 sub-accounts in December 2008, the count now stands at 1,668 and 5,162, respectively.

Many fund managers and investment bankers reckon that foreign investors who missed out on the recent rally in Indian equities may be waiting in the wings for a correction in valuations. Some experts peg the idle cash waiting to be deployed globally at about $4 trillion.

Fine print: Broader fund flow patterns do suggest that the FII money that has been driving this rally came from genuine global investors keen on pegging up their India exposure.

That, however, does not mean that the current rally was devoid of its share of flab. There has been increasing noise about ‘speculative’ money finding its way into our markets.

Experts believe that issues of participatory notes by foreign institutional investors have been on the increase in the last six months. While there aren’t any numbers available on this, it, nevertheless, may remain a point of concern, regardless of how the fund flows pan out in the coming weeks.

Besides, with interest rates in most developed countries until recently at record-low levels, there is also a lurking fear of money made through carry trades entering EMs such as India. Should interest rates begin to climb again as central bankers reverse easy money policies, fund flows could easily be curtailed.
Domestic funds in for long haul

While FII inflows in fuelling the current equity rally has been widely written about, the contribution of mutual funds in delivering the markets through the rout of 2008 has been less acknowledged.

While FIIs were busy selling Indian equities — they net sold equities worth over Rs 52,987 crore in 2008 — mutual funds stepped in with net inflows of Rs 14,112 crore. Even in March this year when the markets hit their trough, while FIIs put in about Rs 530 crore, MF net inflows were almost thrice that at Rs 1,475 crore.

Domestic fund flows from hereon may well pick up if recent inflows into mutual funds sustain.

Mutual funds have, following the recent surge in equities, mobilised gross inflows of Rs 4,796 crore in May alone from the sale of open-end equity schemes. This is by far the highest such inflow since March 2008, when existing equity MF schemes notched up sales of Rs 10,345 crore.

Even new equity MFs appear to be making their presence felt, with a new fund recently collecting over Rs 800 crore, and more offerings lined up. May also marked the first month in 2009 when equity MF sales grew on a year-on-year basis. In addition to this, with equity NAVs also expanding in tandem with the equities surge there is also that much more corpus available for investing.

Besides, mutual funds put together are estimated to be sitting on a significant cash pile, pegged at about 13 per cent of the total assets under management.

While fund managers have deployed cash in the rally — cash as a percentage of the total AUM was as high as 20 per cent in March — they still have enough liquidity on hand.

Fine print: History shows us that given their sheer clout, in the event of a broad-based sell off by the FIIs mutual funds can do little to keep the markets from crashing. History also shows us that mutual funds haven’t been the best timers of the market cycle.

So, while it isn’t wrong to be gung ho about the industry’s increasing AUMs (assets under management) and cash levels, it may not be entirely right to extrapolate this into a bullish market outlook.

Funds are also unlikely to keep on buying if they find FIIs in exit mode. So, while the cash sitting idle with domestic mutual funds will sooner or later find its way into the stock markets, it is the fund flow patterns of global investors that may exercise a greater influence on the near-term direction of the markets.
Key triggers

India story: To what extent India looks attractive to global investors will depend to a great extent on whether India does manage to deliver on its promise of being one of the strongly growing economies in a recession-hit world.

In this respect, the signals of recovery being flashed by the manufacturing sector and the IIP are positive and will need to be closely watched for sustainability.

A policy push for reforms and a roadmap on the fiscal deficit may also be keenly watched by FIIs. Another trigger to watch out for may be earnings upgrades for Indian Inc, with downgrades coming to an end.

Risk appetite: Risk appetite plays a big role in determining the quantum of flows that emerging markets, including India, can attract. While the first signals to the ongoing stock rally came from reviving risk appetite for global investors, the latest data suggests that some of that risk-taking ability may have waned.

For the week ending June 25, investors put in $25.9 billion into Money Market Funds, in stark contrast to the $55 billion of outflows from the same fund group in the previous week (ending June 17).

Whether this signals a mere moderation in risk appetite, a brief phase of profit taking or a reversal is difficult to say at this point of time.

If the BRIC or emerging market pack, long touted for their growth potential, do exhibit signs of continuance in their revival, it may only be a matter of time before investors’ money begins its chase these markets again. However, till such time, a reversal in commodity prices, spike in gold or the dollar will be the key signals of their falling risk appetites.

Rupee-dollar parity: The steady appreciation of the rupee against the dollar has been a key supportive factor for the recent rally, with the BSE Dollex managing a 108 per cent return in this rally compared to the Sensex return of 90 per cent.

Though the fund flows into stock markets had kept the rupee strong against the dollar, not to mention the intrinsic weakness in US currency overseas, any reversal in that may trigger outflows.

While the US Federal Reserve hasn’t so far tinkered with the interest rates, there is growing expectation of it hiking the rates sooner than expected. This may, in turn, strengthen the dollar and reduce returns for FIIs from Indian stocks.

via BL