Analysis-'Modi premium' in India's financial markets set to erode after weak victory

By Karin Strohecker and Caroline Valetkevitch

LONDON/NEW YORK (Reuters) - Indian voters' tepid endorsement of Prime Minister Narendra Modi leaves a weakened mandate for business-friendly reforms and has foreign money managers thinking twice about unleashing another wave of investment in the world's fastest-growing economy.

Modi's Hindu nationalist Bharatiya Janata Party (BJP) secured a third term in government but without a majority of its own for the first time since sweeping to power a decade ago.

India's stock market weathered its heaviest selling since the onset of the pandemic as the votes were tallied and net foreign selling was a record $1.5 billion on Tuesday. Stocks recovered some ground on Wednesday.

With the party losing most ground in rural areas, investors say land and labour reforms, that had been expected to unlock value and growth, will probably fall by the wayside while leaders focus on shoring up rural support which had faltered.

For global fund managers, who despite strong buying last year are generally underweight on India according to HSBC research, the uncertainty is reason enough for caution.

"You have the feeling that while the government was really geared towards business, there are other parts of the country that felt left behind," said Alessia Berardi, head of emerging macro strategy at Amundi Investment Institute - the research arm of Europe's biggest asset manager.

"So a more inclusive economy, a more efficient economy is important," she said.

In the market, stocks trading richly in anticipation of growth driven by infrastructure and manufacturing spending fell heaviest and those exposed to rural demand, such as Nestle India and in motorcycle maker Hero MotoCorp, rose.

Bonds weakened as traders priced risks that welfare spending goes up and budget consolidation is delayed. The tightly-managed rupee skidded to a seven-week low.

"Over the past decade, India has been rewarded with a valuation premium for government stability...some of that valuation premium came out today," said Vikas Pershad, who manages India and Asia equities portfolios for M&G Investments.

"I think priorities might shift a little in the short-term...so more benefits for the rural consumer, the rural working poor."

DEFENSIVE

Investors have prospered under Modi, 73, as India's equity benchmarks have more than tripled since he started as leader in May 2014. Earnings growth drove annualised total return for the MSCI India index to 7.1% over the period, against 1.3% for MSCI's Asia ex-Japan index.

To be sure, investors say the election outcome - with Modi's alliance winning 293 of 543 lower-house seats - is unlikely to derail this trajectory, nor is India's broadly stable currency and attractive debt market likely to be unduly ruffled.

"We're still seeing strong growth coming from India...I think it's a buying opportunity," said Kristina Hooper, chief global market strategist at Invesco in New York.

But few are talking about adding overall exposure and many are adjusting their portfolio following the result.

M&G's Pershad, for instance, who is positive on the market, was on Tuesday a modest seller of defence stocks and a buyer in healthcare. Analysts at CLSA turned defensive, dumping infrastructure conglomerate Larsen & Toubro from their focus portfolio in favour of IT outsourcing firm HCL Tech.

Next year's budget due in July is shaping as the next test of policy commitments, with expectations that India will use a recent windfall surplus from the central bank to reduce the deficit quicker below the targeted 5.1% for the year.

"Typically the budget is used to announce the five-year policies, so we should get a clearer idea of what the game plan is," said Sonal Varma, chief economist for India at Nomura in Singapore.

Foreign money is also sensitive to relative market moves, and gushed into India last year as managers with mandates to invest in Asia took down positions in China's tumbling markets and bought up in India - something that is beginning to reverse.

And uncertainty never helps.

"I'm telling clients don't be in a hurry to invest in India," said Paul Christopher, head of global market strategy at Wells Fargo Investment Institute in St. Louis, Missouri.

"It's still a pretty chaotic place."

(Additional reporting by Ankur Banerjee and Tom Westbrook in Singapore; Writing by Tom Westbrook; Editing by Raju Gopalakrishnan)