Three forces quietly turning on India's recovery?

India's cyclical recovery faces mounting risks from an oil supply shock, waning domestic stimulus, and reduced artificial intelligence (AI) capital expenditure, warns a Nuvama Institutional Equities report. The impact of the oil supply shock on corporate margins is anticipated to materialize in Q2FY27, mirroring the lag seen during the 2022 conflict when small- and mid-cap companies and cyclical sectors faced a sharper decline in profits.

Inventory gains that shielded margins in Q1FY27 are set to dissipate from Q2FY27, the report added.Stemming from the AI investment surge, the positive effect on exports and metal prices might weaken by the second half of FY27, as per Nuvama. This slowdown in AI-related spending may stem from slowing growth, chip cost hikes, heightened competition from China, and dwindling cash flows among major technology firms.

Companies may increasingly rely on debt to fund AI investments, potentially curbing the AI investment boom, according to the report.Additionally, a recent decline in hardware technology stocks, following a sharp rise, could foreshadow a similar market downturn akin to the dot-com bubble burst in 2000, the report cautioned. The stagnation in hardware tech stocks after the recent boom signals a classic late-cycle phenomenon, as witnessed in 2000.

Following the dot-com era, capital expenditures typically contracted, the report observed.Furthermore, a hawkish Federal Reserve and surging global bond yields could exacerbate the pressure on risk assets. More than half of the US, European, UK, and Japanese bond yields have skyrocketed following inflation adjustments. This surge is attributed to tighter central bank policies and shifts in how US dollars are circulated worldwide.

If not curbed, it could dampen risk asset valuations and demand, particularly given the weak consumption and real estate landscape globally. The report also highlighted that India's broadly flat equity market over the past two years conceals a significant degree of polarization, with India lagging emerging markets, large-cap stocks trailing small- and mid-cap stocks, and defensive sectors lagging cyclicals.The disparity in performance is primarily attributed to the AI capital expenditure boom and domestic policy support, with GST cuts and the Reserve Bank of India's regulatory easing bolstering goods consumption.

However, the report cautioned that the cyclical recovery must broaden to preserve the earnings gap, as the low base has largely been exhausted.