2018 Deja Vu: Indian Equities 'Losing Steam' Amid Liquidity Crunch

Before Covid, for over two decades, equities marched in lockstep with emerging markets, mirroring their highs and lows. Even mid-caps and cyclicals followed their global peers closely.

But post-Covid, India rewrote the playbook. Cyclicals and mid-caps soared, making India one of the few markets to defy global trends. Corporate earnings thrived, powered by a tight correlation between exports and top-line growth, while the gross-domestic-product growth outpaced its emerging market peers.

That narrative now, however, has taken a sharp turn, according to Nuvama Institutional Equities. 

Nuvama’s latest report dated Jan. 14 paints a grim picture of a market losing steam. Since October 2024, India's post-Covid decoupling from emerging markets has stalled. Domestic demand is slowing, margin tailwinds have faded, and earnings have reconciled with global peers. Small and mid-cap stocks and cyclicals have borne the brunt of this reversal, plunging 15% from their September peaks.

Adding to the woes is a liquidity crunch, reminiscent of 2018. A double drain from a rising US dollar and higher US Treasury yields has pulled domestic liquidity into deficit — the first time in five years. Sentiment is souring, even as domestic institutional investors continue to pump in funds.

In 2018, the Indian market faced a similar storm. A sharp rise in US Treasury yields drained global liquidity, triggered a 30% correction in the SMIDs and left cyclical sectors like autos, metals and real estate battered. 

Today, mid-caps are already down 15%, and valuations remain stretched— higher even than at the 2018 peak. Unlike then, corporate balance sheets are stronger now, but softer margin improvement levers offer little solace, Nuvama says. 

The key difference? Inflation. In 2018, the carnage stopped when the US Federal Reserve pivoted to rate cuts, restoring liquidity. But this time, inflation is proving more stubborn, stabilising well above its target. The Fed’s bar for a pivot is significantly higher, making a repeat of the 2018 rescue unlikely.

Despite the rise of domestic investors, foreign institutional investors remain the linchpin of Indian markets. The FIIs influence risk appetite, fuelling the rally in the SMIDs and cyclicals even though their direct exposure is limited. But rising USD-UST yields have sparked FII outflows, dragging domestic liquidity into deficit and stalling India's outperformance.

The report warns of more pain ahead for cyclicals and mid-caps. With weakening domestic demand, accelerating earnings downgrades and a liquidity squeeze reminiscent of 2018, the outlook is grim. While a tactical bounce may provide some relief, Nuvama remains underweight on cyclicals and mid-caps, urging caution amid the storm.

The lessons from 2018 are clear: liquidity is king, and when it dries up, cyclicals are the first to bleed. But with the Fed unlikely to pivot anytime soon, the path forward for Indian markets looks challenging, says the brokerage.