Stocks had a record-breaking rally. What’s next?

This report is from this week’s CNBC’s “Inside India” newsletter which brings you timely, insightful news and market commentary on the emerging powerhouse and the big businesses behind its meteoric rise. Like what you see? You can subscribe here.

This enthusiasm isn’t new, though. The Nifty 50 has been on the march throughout the year. There have been 44 record highs set in this year’s 169 trading sessions, according to CNBC’s count.

However, the latest economic data shows what could become the first blemish in the South Asian nation’s perfect growth story. GDP slowed to 6.7% in the second calendar quarter compared to last year’s 8.2%.

Bank of America swiftly downgraded India’s near-term economic growth to 6.8% for the current financial year, compared to previous expectations of 7.2%. The Wall Street bank also sees GDP only modestly rising to 7% the following year, below the Indian central bank’s forecast.

“As signaled by other macro indicators, like low inflation, a small current account deficit, and rapidly consolidating fiscal balances, there is rising slack in the economy,” said BofA’s India economist Rahul Bajoria. “This is further corroborated by evidence of faltering consumer and business confidence, albeit persistent asset price inflation.”

If it persists, the slowdown is likely to become a key risk for equities. Not only will it be the first time that economic growth has cooled since the Covid-19 pandemic, but it would also come at a time when monetary and fiscal policy is tightening.

Domestic politics also pose a risk. If the government redirects spending toward welfare from capital expenditure — a potential shift since Prime Minister Narendra Modi’s party lost its majority in the general election — it risks reigniting inflationary forces while adding downward pressure on companies’ earnings that would have benefited from infrastructure spend.

These risks could reveal themselves in the form of a correction in the equity market — meaning a drop of more than 10% from the most recent peak, according to Morgan Stanley.

But the most surprising worry for investors this week should come from the stock market’s own success.

Indian stocks now have the largest weighting in the MSCI Emerging Markets Investable Market Index with 22.14%, overtaking the 21.5% allocation toward China.

“Rising index weight can be a tell tale sign of exuberance,” said Morgan Stanley’s Ridham Desai in a note to clients on Sept 4. “Of course, it could also be happening due to fundamental factors such as improving free float and rising relative earnings.”

The equity strategist believes that as foreign investors allocate more money toward India, they are being outbid by domestic systematic fund flows, pushing up valuations.

Desai points to China’s history when, in 2008, it became the…