India's Equity Markets Underperform Despite Robust Economic Growth

India's Economic Paradox: Robust Growth Meets Market Skepticism

India's economy demonstrated significant strength in the April-June quarter, with real Gross Domestic Product (GDP) expanding by a faster-than-anticipated 7.8%. This growth marked the fastest pace in five quarters. However, this impressive headline figure belies a more nuanced reality for equity markets. The growth rate, when unadjusted for inflation (nominal GDP growth), registered a three-quarter low of 8.8%. This discrepancy suggests that a lower GDP deflator, influenced by subdued Wholesale Price Index (WPI) and Consumer Price Index (CPI) inflation, contributed to the higher real growth figure, leading to some "noise" in the underlying economic health.

Simultaneously, the revenue growth of approximately 3,000 listed Indian companies across manufacturing and services sectors slowed considerably, reaching a seven-quarter low of 3.4% year-on-year in the first quarter of the current financial year (Q1 FY26). The services sector, a key growth driver, saw its revenue growth halve to 5.8% from 11.3% in the same period last year. This slowdown in corporate earnings, especially in sectors like trade, transport, and real estate, is a critical factor dampening investor sentiment despite the strong GDP number.

Factors Driving Investor Pessimism: Outflows, Tariffs, and a Weakening Rupee

Indian equity markets have faced significant headwinds, primarily from substantial foreign institutional investor (FII) outflows, the imposition of new U.S. tariffs, and a depreciating currency. Foreign investors have pulled a net $15 billion from Indian equities year-to-date, including a sharp $4 billion in August alone, making it the largest monthly retreat this year. Total FII selling for 2024 has exceeded Rs 1.3 lakh crore, raising concerns about India's standing in global portfolios. The selloff was concentrated in sectors such as financial services (Rs 13,471 crore), IT (Rs 6,380 crore), and oil, gas, and consumable fuels (Rs 4,091 crore) during the first half of August.

A major contributing factor to this capital flight is the recent imposition of U.S. tariffs. The U.S. has announced a 50% penalty on Indian exports—comprising a 25% reciprocal tariff and a 25% penalty for India's military equipment and oil trade with Russia. Experts estimate that nearly $35 billion worth of Indian exports are exposed to these higher tariffs, equivalent to about 0.8% of India's GDP. Low-margin, labor-intensive sectors like gems and jewelry, textiles and apparel, leather, and footwear are particularly vulnerable. Textile exporters, for instance, could see their margins shrink by 150 to 200 basis points. While pharmaceuticals often receive different treatment, non-tariff barriers and stricter regulations are anticipated.

The Indian rupee has also reflected this bearish sentiment, sliding to a record low of 88.8050 against the U.S. dollar. This depreciation is partly attributed to the persistent outflow of foreign funds and concerns over potential U.S. policy changes, such as increased H-1B visa fees.

Broader Context & Implications: A Lagging Performance

The combined effect of these factors has left India's benchmark Nifty 50 index lagging its regional peers. The index has risen only about 4% year-to-date, making it the third worst-performing among MSCI Asia countries. This marks its longest stretch of underperformance against the MSCI Asia Pacific benchmark since 2013. The high valuations of Indian equities compared to other emerging markets are frequently cited by FIIs as a reason for rotating capital to cheaper destinations.

Despite the foreign outflows, domestic institutional investors (DIIs) have provided crucial support, investing a record $66 billion into equities this year. On August 29 alone, DIIs invested Rs 11,487.64 crore, cushioning the impact of FII selling and preventing a sharper market decline.

Expert Commentary: Diverse Outlooks and Policy Interventions

Economists and strategists offer varied perspectives on India's current economic landscape. Tanvee Gupta Jain, Chief India Economist at UBS, emphasized the significant challenge posed by the U.S. tariffs, particularly for labor-intensive sectors. Dr. Sajjid Z Chinoy, Managing Director and Chief India Economist at JP Morgan, advocated for targeted support for small enterprises to prevent layoffs, advising against retaliation.

Dr. Samiran Chakraborty, Chief Economist, India, at Citibank, suggested that India needs to rethink its growth model, focusing on strengthening domestic demand amid a shift from globalization to protectionism. He highlighted the potential positive impact of recent GST cuts and direct tax reforms.

In a more optimistic assessment, HSBC upgraded Indian equities to 'Overweight' from 'Neutral' on September 26, 2025. The brokerage cited attractive valuations, supportive government policies, and resilient domestic flows, anticipating the return of FIIs. HSBC analysts also point to a potential "Lollapalooza effect," where a trifecta of GST rate reductions, income tax relief, and lower Reserve Bank of India (RBI) interest rates could collectively boost consumer spending by an estimated Rs 3 lakh crore. This policy combination is expected to particularly benefit discretionary spending and sectors like automotive and consumer staples.

Looking Ahead: Catalysts for Market Reversal

The path forward for Indian equities hinges on several key factors. A clearer outlook on U.S. trade policy and a stabilization of the Indian rupee are crucial for enticing foreign investors back into the market. Analysts from HSBC believe that corporate earnings are near their bottom and are poised for improvement, which could serve as a significant catalyst. Policy actions, such as the continued implementation of GST cuts and other reforms, are expected to bolster domestic demand and provide a cushion against external shocks.

While hopes for a sharp year-end rally have diminished, a normalization of valuation premiums and positive developments in trade discussions could set the stage for renewed interest from global investors. The robust contributions from domestic institutions will remain vital in maintaining market stability, especially as the economy navigates these complex global and domestic pressures. Potential Federal Reserve rate cuts and a weakening dollar could also make emerging markets, including India, more attractive to global capital flows.