Indian equity markets have experienced a significant downturn in 2026, with both the Sensex and Nifty benchmark indices falling by 8-10% over the first eight months. While these indices have recovered somewhat from their March lows, helped by a recent uptick in foreign inflows, a major concern is now casting a shadow over future prospects: the sustained rise in US bond yields.
US Yields and Foreign Investment Dynamics
ICICI Securities highlights that a substantial portion of India's equity assets under management (AUM) from Foreign Portfolio Investors (FPIs), specifically 44% or Rs 31 lakh crore, originates from the United States. The steepening of the US yield curve directly impacts these investors by increasing their risk-free rate.
As the risk-free rate climbs, it concurrently raises the discount rate applied to the long-term growth value of equities for US investors. This trend of escalating long-term bond yields in the US is poised to elevate the hurdle rate for investments into emerging markets (EMs), potentially curtailing FPI equity flows into countries such as India, a stark contrast to the previous era of lower US interest rates.
Current Market Performance and FPI Trends
On a recent Monday, the Sensex was trading lower at 76,951.87, down 0.40%, and has seen a year-to-date decline of 9.67%. The Nifty, meanwhile, was at 24,060.50, up 0.48% on the same day. These figures underscore the volatility and general downward pressure on the markets throughout the year.
Despite the challenges, ICICI Securities suggests that if India's economic growth continues to accelerate, FPI flows could persist even with higher US yields. The India equity premium, measured by the spread of India over the US in terms of Credit Default Swap (CDS) and 10-year bond yield, remains relatively low at 32 basis points and 217 basis points, respectively.
Evolving FPI Landscape
A key concern for Indian equities over the past year has been the significant sell-off by FPIs, coupled with dwindling foreign direct investment (FDI) and FPI debt flows. This situation was exacerbated by geopolitical tensions, particularly the West Asia crisis, which threatened India's current account deficit due to oil price spikes, raising fears about the nation's balance of payments.
However, towards the end of Q1FY27, FPI equity outflows began to recede, giving way to renewed inflows. Simultaneously, FDI and FPI-debt inflows showed meaningful improvement, reaching $7.8 billion and $5.7 billion, respectively, for Q1FY27. During Q2FY27, FPI equity inflows further rose to $5.5 billion, with debt inflows at $3 billion.
ICICI Securities attributes this recent resurgence in FPI inflows partly to a slowdown in the momentum of AI chip stocks in other markets, such as Korea, around July, coinciding with a pickup in India's nominal earnings growth during Q1FY27. While the 'AI stock narrative' is far from over, the raging bull market associated with it appears to be losing some steam.