Morgan Stanley has downgraded its rating on Indian stocks to align with Asia and emerging markets, citing crude supply risks stemming from the Middle East conflict as a key catalyst. Foreign investors net sold $1.3 billion in just two trading sessions, dealing another heavy blow to the Indian stock market.

Citing India's high vulnerability to oil supply disruptions, Morgan Stanley lowered its rating on Indian equities relative to Asia and emerging markets to "equal-weight." After a rebound on Thursday, India's Nifty index weakened again. Regional Asian stock indices are approaching their worst weekly performance in six years.

Oil prices have surged 16% over the past week, while the Indian rupee continues to depreciate. As an economy heavily reliant on crude oil imports, India faces multiple risks including rising inflation, a widening current account deficit, and fiscal pressure. The energy shock has now become a core variable influencing market sentiment.

Data from Indian clearing corporations cited by Bloomberg shows that over the past 10 trading days, cumulative buying of Indian government bonds through channels classified as "others" reached 695 billion rupees, with more than half occurring on Wednesday and Thursday. Market participants believe this includes central bank funds, possibly aimed at curbing the rise in bond yields driven by inflation concerns.

The disruption to India's energy supply from the Middle East conflict is widening. According to the Financial Times, Petronet LNG, India's largest natural gas importer, has issued a force majeure notice to its supplier Qatar Energy due to the inability of vessels to enter ports for loading.

Approximately 40% of India's natural gas supply comes from Qatar. Petronet's major clients include Gail and Indian Oil Corporation, which supply gas to a wide range of enterprises and retail users.

Regarding oil, India's Petroleum Minister stated this week that India has sufficient reserves of crude oil and refined products to handle temporary supply constraints. Government sources indicated these reserves could last about 50 days.

However, the real dilemma lies in future crude procurement directions. After reducing imports of Russian crude for several months, India now faces a difficult choice: resuming Russian oil purchases could anger the Trump administration and harm diplomatic relations with Washington, while waiting for the Middle East situation to improve poses real energy security risks.

Even before this recent shock, valuation concerns had made institutional investors cautious towards the Indian stock market. Indian equities have underperformed their Asian peers for over a year, primarily due to slowing corporate earnings growth. The sudden oil price surge has dampened market confidence just as earnings showed signs of improvement, extending the underperformance.

Pratik Gupta, CEO of Kotak Institutional Equities, noted that the investor conference his firm hosted last week revealed significant divergence and caution. He stated that brokers prefer Nifty 50 constituents but maintain a conservative stance towards small and mid-cap stocks, believing current valuations haven't fallen to sufficiently attractive levels.

Some institutions see selective overselling in the market. JM Financial noted that Reliance Industries, India's largest listed company by market capitalization, has seen its stock price drop over 11% year-to-date, mainly due to foreign investors selling their most liquid holdings, suggesting the decline may be excessive.

On the policy front, the bond market is receiving more "implicit support." Data from Indian clearing corporations shows substantial buying of government bonds through channels classified as "others" over the past 10 sessions, with market participants attributing this activity potentially to the central bank.

This move is seen as potentially aimed at containing yield increases driven by inflation and fiscal deficit concerns from rising oil prices, while also offsetting the liquidity drained from the banking system due to the central bank's recent currency interventions.

Despite ongoing fundamental pressures, the Nifty index showed noteworthy technical signals on Thursday. The index found support near its 100-week moving average and staged a rebound, recording its largest single-day gain in over a month.

This moving average has historically served as a long-term support level for Indian stocks during stressful periods, with the only definitive breach occurring during the global market panic triggered by the 2020 pandemic. Historical data indicates that after rebounding from this zone, the Nifty typically follows with a 5% to 10% rally.

However, whether this technical signal translates into a sustained recovery will depend on the evolution of the Middle East situation and subsequent oil price movements. On Friday, regional Asian stock indices declined again, with the week's overall performance nearing the worst in six years.