The two-day US Fed rate-setting meeting that ends on Wednesday will have a big say in the near-term outlook for Indian shares, which this week fell the most in three months partly on worries an earlier-than-expected increase in interest rates by Washington would stem the flow of global funds into the South Asian nation.

The top-30 Sensex dropped 3.2 per cent to 28,503.30, its biggest weekly loss since the week ended December 12 and 5.1 per cent off the all-time high of 30,024.74 struck on March 4 after the central bank unexpectedly lowered its key policy rate. It is quite possible for the benchmark to more than double the percentage loss from the peak if an US rate rise is advanced, according to brokers.

The 50-share Nifty closed with a weekly fall of 3.3 per cent at 8,647.75, and down 5.2 per cent from its record high of 9,119.20.

“The key vulnerability to Indian equities remains any potential dislocation in global financial markets,” equity analysts Bharat Iyer and Bijay Kumar at JP Morgan said in a report. The market’s rally to historical highs was powered by robust foreign portfolio inflows, which have topped $5.5 billion since start of January.

“In this backdrop, we believe investors would do well to watch the trend in the US Fed’s monetary policy closely, as this could have a meaningful impact on the performance of Indian markets, particularly over the near-term.”

The US investment expects the Fed to start raising rates in June, compared with consensus forecast of September. Because most foreign brokerages are currently heavily overweight on India, any whiff of a shift in funds to the US could quickly raise the risks to domestic stocks.

“The (US) bond market is pricing in around a 1 in 3 chance of a June rate hike. We believe this reflects a reasonable assessment of risk,” Morgan Stanley analysts Ellen Zentner, Ted Wieseman and Robert Rosener said in a preview. “The probability of a rate hike at the April meeting that the market has priced in is negligible.”

Higher inflation

A rise in domestic inflation for the third straight month would also weigh down on the market because it could dampen expectations for the pace of easing by the Reserve Bank of India, and the still sluggish recovery in manufacturing growth.

Consumer price inflation accelerated to 5.37 per cent in February, above market expectations as well as from an upwardly revised 5.19 per cent in January, with food prices climbing to 6.79 per cent from 6.06 per cent. Industrial output slowed to 2.6 per cent in January from 3.2 per cent growth in the previous month.

The data along with potential inflationary pressures building up could narrow the room for the RBI to reduce rates aggressively, investment bank HSBC said, adding that it expected “a final 25 basis points cut in June”.

“The uptick in food inflation could continue into March with rain disruptions over last month causing some short term flare ups. Some of the finer points around the budget, such as service tax, railway freight fares and retail oil price increase could also add to inflationary pressures. Finally, as domestic demand picks up gradually in the coming quarters, pressure on core components could intensify,” HSBC said.

The government and the RBI have set a consumer inflation target of 4 per cent from next year, with a band of plus or minus 2 percentage points.

Even as UBS India Securities remain “directionally positive” on Indian markets, it believes profit-taking and consolidation were likely to be the near-term trend.

“We remain over weight banks as lower rates are a bigger driver versus growth for stocks — HDFC Bank, Axis Bank and SBI are top picks,” analysts Gautam Chhaochharia and Sanjena Dadawala said in a report. “We also like ITC, Maruti, Lupin and ONGC. Our least-preferred stocks are Hero MotoCorp, Bajaj Auto, HUL, Infosys and Jubilant Food.”

Conflicting signals

Although Prime Minister Narendra Modi rode to power last May on the promise of kick-starting investment and growth, the administration has been facing strong political opposition to open up the economy as well as push critical reforms. Additionally, some of the government action is cause for heartburn.

The tax authorities, notorious for slapping controversial demands that have scared away foreign investors, were at it again this week when it asked oil explorer Cairn India Ltd to pay $3.3 billion, including interest, for failure to deduct capital gains tax on a share transfer pricing dating to 2007. The company, now controlled by Anil Agarwal’s Sesa Goa Ltd after group firm UK-listed Vedanta Resources acquired majority stake in 2011, was aghast.

Earlier this month, the taxmen had also sent a $1.6 billion claim to London-based Cairn Energy Plc, the parent of Cairn India which continues to own 9.82 per cent in the Indian unit.

Finance Minister Arun Jaitley had reiterated in his budget the government would not use retrospective tax action — although he did not repeal the powers in the statute. In January, the government decided not to pursue a similar claim against Vodafone Plc after the issue became a hot potato for the authorities.

At a time when the government is wooing foreign investors to its shores, the message that goes out with issues such as the Cairn tax claim is catastrophic.

The writer is a journalist based in India.