Cloudy outlook for Indian equities in 2026

ANALYSTS turned more constructive on Indian equities in late 2025, despite the market’s underperformance relative to its Asian peers.

Major banks such as Goldman Sachs, HSBC and Morgan Stanley have recommended an overweight stance, citing reasons such as an anticipated earnings recovery and pro-growth policies supporting India’s economy.

While these arguments are valid, we believe there are reasons to remain cautious.

Earnings recovery amid valuation concerns

The Modi government has done a good job of stimulating growth in an economy hit by the most punitive US reciprocal tariffs in the region. Third-quarter gross domestic product growth came in at 8.2 per cent, well above market expectations of 7.4 per cent.

Pro-growth policies such as personal income tax cuts, GST reforms and repo rate cuts have all helped to revive urban consumption.

India’s financial sector looks poised for a rebound, with earnings potentially returning to double-digit expansion as credit demand picks up. Repo rate cuts of 125 basis points last year have made borrowing more affordable, while the cash reserve ratio’s drop from 4 to 3 per cent has freed up additional liquidity, giving banks the capacity to lend more.

The combination of stronger loan demand and greater lending ability should translate into meaningful revenue growth in the sector.

Consumer discretionary stocks are likely to benefit as well, as lower borrowing costs and GST-driven price cuts encourage households to spend more on non-essential goods such as automobiles.

While the economic backdrop and earnings recovery are encouraging, lofty valuations remain a key concern. At 24.4x forward price-to-earnings (PE), the Sensex is trading more than one standard deviation above its 15-year average of 15.9x, leaving little room for multiple expansion.

In other words, Indian companies will likely need to deliver exceptionally strong earnings growth for equity prices to move meaningfully higher.

Weak Indian rupee may dilute returns

Rupee weakness has long been a headache for foreign investors in Indian equities, and there is little reason to expect that to change in 2026.

The currency hit record lows in December, crossing the 90 USD/INR level, which some traders had expected the Reserve Bank of India to defend. Instead, the central bank allowed the rupee to weaken, and understandably so.

Inflation stayed subdued at 0.71 per cent as at November, well below the RBI’s 4 per cent median target. This means imported inflation is hardly a concern. A softer currency would help bolster India’s export competitiveness.

A US-India trade deal could provide some relief. Lower reciprocal tariffs would support exports and increase demand for the currency, but a sustained stabilisation would likely require a broader shift in investor sentiment and the return of foreign capital to Indian equities.

For that to happen, we would require either a stronger-than-expected earnings rebound or a significantly more favourable trade agreement than currently anticipated – and neither appears likely at this stage.

Limited participation in global AI rally

Foreign capital is likely to keep flowing towards leaders in artificial intelligence (AI) in 2026. This is an area where India remains notably underrepresented.

Investors asked to name AI companies would probably list the usual names: Nvidia, Broadcom, Alphabet. In Asia, Tencent, Taiwan Semiconductor Manufacturing Company (TSMC) and SK Hynix are familiar names, too. But it is much harder to cite an established Indian company with meaningful, large-scale AI exposure.

Part of the reason is India’s late entry into semiconductors. While TSMC has already begun mass-producing cutting-edge 2-nanometre (nm) chips for AI applications, India is focusing on mature nodes in the 28 to 65 nm range to meet demand in the automotive, telecoms and industrial sectors.

India’s Technology Minister Ashwini Vaishnaw has said that the country’s chipmaking capabilities could match that of other major producers by 2032. But we think this is highly ambitious, given the scale of challenges, ranging from a lack of specialised talent and infrastructure gaps, to the fact that incumbent chipmakers are innovating rapidly.

One potential bright spot for India lies in its IT services sector. Companies such as Infosys and Tata Consultancy Services are pivoting away from traditional digital-transformation projects towards AI-centric deals, even as they invest heavily in AI capabilities to deliver services more efficiently. This positions them as potential beneficiaries of the AI trend over the longer term.

Still, the transition is unlikely to be painless. As the sector has historically relied on billable hours and headcount-driven growth, greater use of AI could weigh on near-term revenue by reducing the number of hours billed to clients.

Coupled with existing headwinds such as soft global IT spending and changes to the H1-B visa regime, we do not expect a strong uplift in IT earnings growth in the near term.

Stay cautious

Investing in India could be a good hedge against the AI rally fizzling out, but taking an overweight position seems a little excessive. Elevated valuations may limit upside, while a continued weakening of the rupee could eat into returns for foreign investors.

Investors will likely be better off overweighting other emerging markets such as China and Taiwan, where valuations are cheaper and the structural growth story is stronger.

The writer is a research analyst with the research and portfolio management team of FSMOne Singapore, the B2C division of iFast Financial