Indian stock market outlook: Nikunj Saraf prefers large-caps, cautions against small-caps

Since India imports nearly 90 per cent of its crude oil, higher prices feed directly into inflation, the current account deficit and corporate margins. Our assessment is that the economy can absorb prices of up to $90–95 per barrel. The discomfort zone begins around $100, while sustained prices above $110–120 would become a serious concern. The current account deficit could cross 2.5 per cent of GDP, retail inflation could breach 6 per cent, and the rupee could test 98–100 against the dollar. Equities can tolerate volatility, but they struggle with a prolonged oil shock.

BT: With global bond yields and interest-rate expectations influencing capital flows, how should investors assess the outlook for Indian government bond yields and the RBI’s rate trajectory? Which sectors would be most sensitive to a change in yields?
Saraf: The regime has clearly changed. On October 7, the RBI raised the repo rate by 25 basis points to 5.50 per cent, marking its first hike in nearly four years, and shifted to calibrated tightening. Governor Malhotra signalled that rate cuts were off the table in the near term.

The benchmark 10-year government bond yield has risen for eight consecutive weeks to a three-year high of around 7.37 per cent, pressured by open market operation (OMO) sales and tighter liquidity. Investors should factor in the possibility of one more rate hike, which could take the repo rate to 5.75 per cent. The 10-year yield could move towards 7.5 per cent before stabilising as inflation peaks.

For debt portfolios, we prefer the short-to-medium end of the yield curve and high-quality accrual strategies over duration bets. In equities, the sectors most sensitive to yields include banks, non-banking financial companies (NBFCs), real estate, automobiles and capital goods, where funding costs and valuations tend to move inversely with interest rates.

BT: Foreign portfolio investor (FPI) flows remain a key driver of market sentiment. What could trigger a sustained return of foreign money to Indian equities, and can domestic institutional investors (DIIs) continue to absorb foreign selling without putting pressure on valuations?
Saraf: Foreign flows are the swing factor for market sentiment, and 2026 has been a difficult year. FPIs have withdrawn a record Rs 3.12 lakh crore from Indian equities, nearly double the Rs 1.66 lakh crore withdrawn last year, with more than Rs 52,000 crore leaving in October alone.

The triggers have been external: crude oil prices, a stronger dollar and higher US bond yields, alongside an AI-led rally that has attracted capital towards North Asia. A sustained return of foreign money would require this backdrop to improve, with crude prices cooling, the rupee stabilising, US yields peaking as the Federal Reserve eases policy, and corporate earnings delivering growth.

Encouragingly, FPIs turned net buyers on October 16, ending a 15-session selling streak. DIIs, meanwhile, have absorbed much of the selling, investing Rs 6.83 lakh crore this year amid steady systematic investment plan (SIP) inflows. This provides a meaningful cushion, but it is not unlimited. If domestic flows weaken, valuations could lose their main source of support.

BT: How could further depreciation or a recovery in the Indian rupee affect foreign investor sentiment, corporate earnings and sectoral performance? Which sectors are likely to benefit from a weaker rupee, and which could face margin pressure?
Saraf: The rupee reflects the broader macroeconomic picture. It touched a record low near 97 against the dollar in early October before the RBI’s rate hike and intervention helped it recover to around 94.9, marking its strongest weekly performance in seven months. Forex reserves have been drawn down to approximately $726 billion to support the currency.

Further depreciation could erode foreign investors’ returns and trigger a self-reinforcing cycle of outflows. Conversely, a stable or stronger rupee would be a positive signal for FPIs considering a return to Indian equities.

Sectorally, a weaker rupee benefits dollar-earning businesses such as IT services, pharmaceuticals, specialty chemicals and textiles by improving translated earnings and competitiveness. The pressure falls on importers and companies with unhedged dollar-denominated costs or debt, including oil marketing companies, airlines and capital goods manufacturers that rely on imported inputs. For most portfolios, exposure to high-quality exporters can provide a sensible natural hedge.

BT: What are the key takeaways from the ongoing Q2 earnings season so far? Are corporate earnings showing signs of a recovery, and which sectors are best positioned to deliver earnings growth in the coming quarters? How much of the earnings outlook is already priced into current valuations?
Saraf: Q2 is shaping up to be the strongest earnings quarter in nearly three years, with aggregate Nifty profit growth tracking 20–27 per cent year-on-year. If realised, this could be the strongest growth in 17 quarters. However, context matters: the comparison is flattered by a weak base, as Nifty earnings per share (EPS) grew by barely 1.6 per cent in FY26.

Growth is also concentrated, with oil and gas, metals, automobiles and financials doing much of the heavy lifting. Tata Motors and Reliance Industries are among the biggest contributors. Early results from IT companies have been steady rather than spectacular.

A more encouraging signal for investors is valuations. The Nifty is now trading around 18 per cent below its long-term average valuation multiple, suggesting that considerable caution is already reflected in prices. The key risk to monitor in the second half of the year is margins. If crude oil prices remain elevated, higher input costs could erode part of the earnings recovery.

BT: With a strong IPO pipeline and several large offerings expected, can India’s primary market sustain its fundraising momentum amid volatile secondary markets? Are IPO valuations becoming stretched, and should investors be more selective about fresh issues?
Saraf: The primary market has been remarkably resilient. In 2026, more than Rs 1.1 lakh crore has already been raised through roughly 96 mainboard IPOs. The pipeline is substantial, with around 217 companies worth close to Rs 3.86 lakh crore, led by Jio Platforms’ issue of more than Rs 30,000 crore, which is set to be India’s largest IPO.

Fundraising momentum can continue because much of it is supported by strong domestic liquidity rather than foreign flows. However, there are two reasons for caution. First, a large share of recent issuance has been through offer-for-sale (OFS) transactions. Around 61 per cent of this year’s mainboard fundraising has come from existing investors selling their stakes rather than companies raising fresh growth capital.

Second, valuations in some segments remain stretched, and investors have become more selective about pricing. In a volatile secondary market, discipline is essential. Investors should evaluate each issue on its fundamentals and valuation rather than scarcity or hype.

BT: Given the combination of geopolitical uncertainty, crude oil volatility, currency fluctuations, foreign fund flows and corporate earnings, what is your outlook for the Nifty and Sensex over the next three to six months? Should investors focus on large-cap stocks, mid-caps and small-caps, or adopt a more defensive strategy?
Saraf: We see the next three to six months as a period of range-bound consolidation rather than a market with a clear directional trend. The Nifty, currently near 23,000 after recovering into the 22,800–23,100 range, remains around 12 per cent below its January peak and has corrected much of its earlier excess.

The market’s direction will depend on four variables: cooling crude oil prices, a stable rupee, a shift towards monetary easing by the US Federal Reserve, and sustained earnings momentum. If these factors align, a gradual recovery is possible. However, a spike in crude prices or continued foreign outflows could push markets towards lower support levels.

We favour quality large-cap stocks, which offer greater earnings visibility and more comfortable valuations, complemented by selective mid-caps in financials, healthcare and domestic-facing sectors. We would remain cautious on richly valued small-caps. This is a market in which investors should accumulate systematically through SIPs and on market dips rather than chase rallies. Strong balance sheets and cash flows matter again.