Suddenly, India is not the big story

This is absolutely the worst time of the year to visit Western Europe. Temperatures are holding in the mid-thirties and there hasn't been much rain. In fact, South England has officially declared a state of drought with restrictions on the use of water. The use of garden sprinklers and hose-pipes, for instance, has been banned.

The English, whose passion for gardening borders on obsession, are horrified. European houses are equipped to handle Arctic gales, not tropical heat waves. Most don't have air-conditioning and their boxy structures tend to trap heat, creating an oppressive sauna effect. To cut a long story short, most of Western Europe is, quite literally, under the weather.

There is also a severe drought of interest in emerging market investments, including India. The apathy towards India seems a little more pronounced, perhaps because of the fact that just six months ago the very same fund managers were completely sold on the India story.

It is difficult to pinpoint the exact reasons for this change of heart. There is a vague fear that interest rates will keep rising and hurt company profits and treasury earnings of banks.

To some investors, the fact that Indian consumers have been shielded from the global oil price spiral means that there is a time-bomb ticking away somewhere. Were oil prices to rise further, it's bound to translate into higher inflation or larger subsidies. Both imply higher interest rates.

There is the added fear of high input prices manifesting in weaker operating margins for Indian firms going forward. Thus, even if volumes were to grow, the shrinking wedge between output and input value would damage prices. While fund managers are aware that pricing power has been picking up, the dominant perception is that it is restricted to a few sectors like cement. Other sectors, they feel, will be caught in the pincer of dwindling product prices and ballooning costs.

Emerging market investors have also entered a phase where they have completely lost their appetite for positive news. Yet, when it comes to bad news, they are ravenous. Let me take a couple of examples.

Despite the unexpectedly positive data last month on last year's current account deficit for India (the deficit came in at $10.3 billion when the consensus expected $20 billion) and the growing pile of foreign exchange reserves, investors still have a niggling fear that sharp currency depreciation will eat into portfolio values.

They are indifferent to the bigger picture, which suggests that the current account deficit is well under control and the central bank is likely to successfully stave off a run on the currency.

Profit numbers of Indian companies for the first quarter of the year seem to have beaten expectations in most cases and analysts across the board have upgraded their forecasts for the year.

For the 100-odd companies that have published results for this quarter, sales have grown by about 30 per cent and the bottom line has moved up by a searing 48 per cent. The consensus forecast for earnings growth for the current fiscal is more than 20 per cent, up from 15 per cent at the beginning of the year.

With the stock market down by more than 20 per cent from its high this year, company results and forecast upgrades like these should make a compelling case for looking at India afresh. However, most funds have given these numbers the cold shoulder.

Global economic and political uncertainty has done little to dispel this bearishness. Fed Chairman Ben Bernanke might have sounded a little less severe on inflation and interest rates in last week's testimony to the US Congress but hasn't quite succeeded in quelling fears of further tightness in global liquidity.

In fact, some money managers are willing to bet their last penny that if the US inflation data print slightly higher in the coming months, the Fed could slip back into tightening mode.

The crisis in the Middle East has frayed nerves, and the US's explicit support for Israel's over-the-top aggression has left people wondering whether another protracted conflict in the region has just begun.

This is of course a dream scenario for a contrarian investor who believes in the fundamentals of the India story. From what I hear from colleagues, there are some brave hearts who are buying into the volatility that's been buffeting the Indian stock markets.

In fact, the current situation has all the makings of a lull before a bull run. Investors are known to move in herds and prone to sharp, collective mood swings. I would not be surprised if by the end of the year, Indian stocks are back in fashion.

Until then, we need to brace ourselves for patchy flows into the domestic stock markets and its consequences for other asset prices like the currency. I, for one, see the volatility in the rupee continuing over the next few months.

The RBI is likely to be concerned about this since every dip in the rupee's value makes imports a little dearer and adds to domestic inflationary pressures. One way to tame the currency's volatility is to hike domestic signal interest rates.

Thus, if the RBI has similar forecasts as mine for capital flows, I wouldn't be too surprised if it hikes the "repo" rate in tomorrow's mid-year monetary policy review. Markets move in mysterious ways. If there is indeed a rate hike and the rupee stabilises as a result, the revival in foreign portfolio flows could be quicker than I expect.