Markets
Mint Explainer: Nifty earnings yield and its impact on FPI buying
Summary
- When the 10-year US bond yield outperforms the Nifty earnings yield, narrowing the spread, FPIs tend to sell risky EM assets to park their funds in the safety of the US dollar bonds.
Mumbai: Foreign investors recently flocked to US bonds, booking profits in emerging markets (EMs) like India and repatriating some of their gains to the safety of the dollar. Their sharply reduced purchases of Indian equities so far this month correspond with a global equity selloff prompted by Fitch Ratings’ downgrade of the US sovereign rating which spurred rallies in Treasury yields and the dollar.
Last week, Fitch Ratings cut the US’s sovereign credit grade one level to AA+ from AAA, two months after it warned the rating was under threat due to oft-repeated political standoffs on the debt ceiling.
While the downgrade might have been the trigger for the slowing pace of foreign fund buying, the narrowing gap between Nifty earnings yield and the 10-year US bond presaged their caution. Against an average monthly net purchase of ₹31,400 crore through March to July, they net bought equities worth a modest ₹285 crore during 1-7 August.
Will they turn net sellers after all these months?
That depends upon how the spread between the Nifty earnings yield and the US 10-year bond moves. Essentially, when the 10-year US yield outperforms the Nifty earnings yield, narrowing the spread, foreign portfolio investors (FPIs) tend to sell risky EM assets to park their funds in the safety of the US dollar bonds.
The earnings yield here is the 12-month Nifty earnings divided by share price (inverse of the price to earnings or PE ratio). The current Nifty earnings yield is 4.5% and the 10-year bond yield is around 4%, translating into a spread of 0.5%, against a 0.74% average spread over the past one year. A year ago, the yield was at 4.26% and the US bond was at 2.75%, or a 1.51% spread .
When the spread was 1.51%, FPIs net invested ₹51,204 crore in Indian shares, the highest since December 2020 and a figure not seen since then.
Since August last year, however, the Nifty earnings yield has grown just 24 basis points, or 0.24%, while the US 10-year bond yield has increased by 125 basis points, taking cues from the Fed Funds Rate, the rate at which the US central bank lends to banks, rising from 2.5% in August last year to 5.25% currently to tame high retail inflation. If the spread narrows further or turns negative, FPIs could dump Indian shares and reinvest their money into US bonds.
Dollar vs Rupee
There is also a currency risk when FPIs borrow cheap in their home country and invest in EMs like India. For, if the rupee depreciates against the dollar between the time of their investment into the Indian market and their exit, their dollar gains reduce as they get fewer dollars at the time of repatriating funds from India. This, along with the narrowing spread, acts as a disincentive for incremental investments.
If the Rerserve Bank of India holds its policy rate at 6.5% at its next bi-monthly policy meet concluding on 10 August, the dollar could strengthen more against the rupee given that the Fed hiked its policy rate by 25 basis points only late last month.
If the spread between the Nifty earnings yield and the US benchmark bond narrows more, FPIs might be dis-incentivised to invest incrementally in Indian shares, especially if the rupee weakens more and earnings growth slows. That increases their risk as they pay a cost to hedge currency risk, besides risking their leveraged money on volatile EM markets.
FPIs had been net buyers during 1 April to 7 August to the tune of ₹1.49 trillion, two financial years after being net sellers of a combined ₹1.78 trillion . Thus earnings growth of Indian companies would play a crucial role in their participation in Indian markets. Aside of banks and autos, and the occasional O&G, the earnings of other key sectors like IT and FMCG have not been too impressive in the June quarter.
