FII comeback unlikely in large numbers even after AI trade peaks: Bernstein

The latest market report highlights that Foreign market participants may not return to Indian equities in large numbers even after the artificial intelligence-led investment trade peaks, according to Bernstein, which says the challenge facing India's foreign flows is deeper than a temporary rotation in global capital.

“We do not believe FIIs will return in large numbers even after the AI trade peaks,” the brokerage stated in its latest India strategy report.

Bernstein's argument is not that foreign market participants will stop trading Indian equities. Instead, it questions whether India still offers the combination of expansion, valuation and returns that can backing a sustained allocation of global capital.

That distinction is important because the brokerage anticipates some cyclical foreign flows to return if crude prices decline, earnings expansion accelerates or India's macroeconomic backdrop improves. But it does not see those factors as enough to restore the earlier structural FII cycle.

Why the old FII playbook no longer works

Bernstein's report traces the changing relationship between foreign flows and India's market over several periods.

Historically, stronger Indian economic expansion was closely associated with elevated FII inflows. That relationship softened over time. The India-US interest-rate differential subsequently became a more important driver of foreign flows, particularly between 2012 and 2018, but that relationship additionally faded around 2019.

In recent years, Bernstein says, relative valuations, currency returns and forward earnings revisions have become more relevant to foreign market participants.

None of those factors at present provides a straightforward reason for a large structural return of foreign capital, according to the brokerage.

The shift matters because it changes what India needs to deliver to attract global market participants. Firm headline GROSS DOMESTIC PRODUCT expansion alone is no longer enough if foreign market participants are simultaneously facing high relative valuations or weak currency returns.

Valuation has become a bigger hurdle

Bernstein finds that India's valuation premium to other emerging markets has become increasingly relevant to FII flows, particularly after 2020.

Its analysis reveals that periods of elevated relative valuations have more often coincided with FII outflows in recent years.

The indian rupee has additionally become a much stronger factor. Bernstein estimates the recent correlation between the currency and FII flows at 72.9 percent, while the relationship with the dollar index has additionally strengthened.

The brokerage notes that FII flows themselves influence the indian rupee, making the relationship two-way. But it additionally sees a potential feedback loop in which currency softness reduces foreign market participants' dollar returns, which in turn can encourage further selling.

That means a return of foreign capital is no longer simply a question of whether India's economy is growing faster than before.

Earnings expansion alone may not bring FIIs back

Bernstein additionally finds that current or recent-quarter earnings expansion has not had a consistently meaningful relationship with FII flows.

Forward earnings revisions, particularly revisions to the next quarter over a three-month window, have shown a stronger relationship in some periods.

This is another reason the brokerage is wary around assuming that a few firm earnings quarters would automatically bring foreign market participants back.

The distinction is between cyclical improvement and a structural change in how global market participants view India.

AI trade is not the missing piece

Bernstein's assessment additionally challenges the idea that India is simply waiting for money to rotate out of the AI trade.

The brokerage says global capital has more alternatives than it did in previous cycles, while market participants are additionally assessing risks around AI-fuelled changes to business models.

For India, Bernstein points to a combination of valuation, liquidity and execution risks, alongside regulatory and subsidy burdens and vulnerabilities around energy security, as factors that make a long-term structural allocation harder.

It as a result rejects the assumption that once the AI trade peaks, foreign money will simply be redirected towards India.

The brokerage puts the point bluntly: “they will return to ‘trade’ but have little reason to invest. At least not yet.”

That distinction is central to Bernstein's latest India call.

India's FII question is now “why”, not “when”

The shift is visible in the flow data as well.

Bernstein says the last month in which FII inflows exceeded roughly $5 billion was September 2024. In the preceding 24 months, FIIs had invested $38.6 billion in India. In the subsequent 24 months, they had withdrawn $56.3 billion, according to the report.

The brokerage argues that this changes the question market participants should be asking.

“The billion-dollar question is not when the FIIs will return, but why they would return, if at all they do,” Bernstein stated.

That is additionally a departure from India's earlier FII cycle, when two to three years of foreign inflows were typically followed by a period of weaker flows. Bernstein says the pattern during the past four years has been different: domestic institutional flows have continued to scale up, while FII troughs have become deeper.

Foreign money is not simply waiting on the sidelines

Bernstein additionally cautions against assuming that two external developments – a settling of the AI trade and an easing of the Middle East crisis – will automatically release capital for India.

“It would be a folly to think after AI trade settles and Middle East crisis resolves foreign money is simply waiting to be parked into India,” the brokerage stated. “It is not, and it’s time India realizes this.”

That does not amount to a prediction that FIIs will never return.

Bernstein says cyclical flows can still revive if crude prices slide, earnings expansion accelerates and macroeconomic conditions improve. Its 12-month market view stays flat to modestly positive, but it says that outlook reflects an easing of recent headwinds rather than a structural improvement in India's foreign-investor proposition.

The longer-term revival, in Bernstein's view, requires India to build globally competitive industries and firms capable of winning global market share.

Until then, the brokerage sees a fundamental difference between foreign market participants returning to trade India's market when conditions become favourable and returning to make the kind of long-duration structural allocation that characterised earlier FII cycles.