The Indian domestic market and economy have been keenly observing the progress of trade negotiations with the United States over the last six months. There was heightened expectation in the recent two months that the US would at least eliminate the 25% penalty tariff. However, persistent delays are now anticipated to dampen market sentiment, compounded by cautious foreign institutional investors (FIIs), a depreciating Indian Rupee, and a volatile export outlook. This postponement is likely to extend India's period of underperformance, which analysts foresee continuing into 2025, at least in the initial part of the new calendar year.
The Two-Phase Challenge and Sectoral Vulnerabilities
A core issue with the anticipated agreement is its proposed structure, expected to be finalized in two distinct stages. The first phase would involve the removal of the 25% penalty, followed later by a more comprehensive trade pact. The latter stage is complex, as it involves US demands for India to further open its economy, specifically in sensitive areas like agriculture and dairy, where India maintains protections for its small-scale farmers. While India has successfully forged comprehensive free trade agreements (FTAs) with nations like the UK, UAE, Australia, and others based on mutual principles, meeting Washington's requirements presents a significant hurdle that will likely delay the final deal.
Sectors with substantial exposure to US business are particularly at risk from these delays. Industries such as IT, Pharmaceuticals, Textiles, and Jewellery could face adverse impacts either through direct loss of business or negative investor sentiment stemming from the prolonged uncertainty.
Global Pressures and Domestic Market Risks
There is a growing view that the US faces its own pressures to conclude trade deals with major partners like China and India, given its heavy reliance on imports. A potential shortage of resources could drive consumer prices higher, fueling inflation and testing the limits of protectionist policies. So far, the effect on US inflation has been milder than predicted, aided by high inventory levels and cost-sharing between suppliers and buyers. Yet, as inventories shrink and corporate profits dip, this buffer may not hold.
Notably, post-pandemic inflation played a role in the Democratic Party's loss in the 2024 US election. As the 2026 midterm elections approach, the Trump administration might consider softening its stance. Recent reports indicate the US has started reducing tariffs on some key consumer imports. However, if inflation remains controlled, Trump's tariff policy could persist, and given the current state of US-India relations, such a scenario would not be welcomed by the markets.
FII Outflows and External Market Headwinds
Additional risks for Indian equities include sustained FII outflows, driven by India's premium valuations and a modest earnings outlook. This trend may continue as profit-taking gains momentum in emerging markets after strong performances in 2024 by peers like Japan (up 26%), China (24%), South Korea (79%), and Taiwan (29%), led by manufacturing and AI sectors. Globally, markets are also witnessing a contraction in the AI investment boom.
Concerns are mounting that AI-related stocks are overvalued and a market correction may be due, as revenue generation from artificial intelligence has not met lofty expectations. The sector also requires massive capital expenditure over the next five years. While India is not a primary AI generator and may avoid a direct hit, its technology sector could feel the ripple effects through slower revenue growth. The broader domestic market remains susceptible due to high valuations and weak FII sentiment.
Furthermore, the risk of a reversal in the yen carry trade is increasing, propelled by rising Japanese bond yields. This could put pressure on emerging markets collectively, including Indian equities, which are a key component of the EM basket. The overall impact on India might be somewhat muted, considering its relatively poor recent performance and lower FII exposure anticipated in 2025, which reduces short-term positioning risks. Nevertheless, with India's valuations still hovering above long-term trends, the country's underperformance could persist in the near term as external issues continue to be a point of concern for the domestic market.
(Analysis by Vinod Nair, Head of Research at Geojit Financial Services)
