India's Slowing Services Sector: Implications for Growth-Driven Investors

India's services sector, long the engine of its economic growth, has shown signs of moderation in Q2 2025, raising questions for growth-driven investors navigating emerging market equities. While the sector contributed 54.93% of Gross Value Added (GVA) in 2024-25, its growth rate dipped to 5.4% in Q2 2025-the lowest in over two years-according to HSBC's India Services PMI. This slowdown, driven by weaker overseas orders and global competition, contrasts with the sector's earlier resilience in FY25, when it outpaced agriculture and industry, as noted in an RBI Annual Report. For investors, the shift underscores the need to reassess exposure to India's services-heavy economy and rebalance portfolios toward sectors with stronger structural tailwinds.

The Services Sector: A Mixed Picture

The services sector's growth has historically been buoyed by India's digital transformation and robust private consumption. In Q1 2025, it expanded at 7.2%, reflecting strong urban demand and infrastructure investment, according to a Q1 GDP report. However, Q2's deceleration highlights vulnerabilities, particularly in export-dependent subsectors like IT and business services. While domestic demand remains resilient-driven by a growing middle class and government spending-global headwinds, including U.S. tariffs and China's economic rebalancing, have dampened overseas order growth, according to a TAC Economics outlook.

Despite the slowdown, the sector's dominance in India's GDP structure means its performance continues to shape macroeconomic outcomes. The Reserve Bank of India (RBI) projects services growth at 7.1% for 2025-26, a slight moderation from 7.5% in FY25, per an RBI publication. This trajectory suggests a transition from high-growth momentum to a more sustainable, albeit slower, expansion phase.

Investor Rebalancing: Shifting Priorities

The services slowdown has prompted a strategic reallocation of capital within emerging market portfolios. Institutional investors, including Franklin Templeton and Mirae Asset, are increasingly favoring sectors with durable earnings and lower global exposure. Financial services, for instance, has emerged as a key overweight position, supported by improving credit quality and stable return on equity (ROE), according to a sector rotation analysis. Telecom, too, has attracted attention due to rising average revenue per user (ARPU) and capex efficiency, as discussed in BNP Paribas' India equity strategy.

Conversely, IT and pharmaceuticals-once darlings of India's services sector-face scrutiny. Global demand for IT services has softened, with total contract value (TCV) attrition rising, according to an M&A report. Meanwhile, pharmaceuticals have seen valuation corrections, though long-term potential remains tied to domestic R&D and hospital growth, as noted in a deal-making report.

The rebalancing is also evident in fund flows. Foreign Institutional Investors (FIIs) injected ₹22,910 crore into financial services in April 2025, while capital goods and infrastructure firms like L&T and BHEL attracted significant inflows, per FII trends. Domestically, sectoral/thematic funds-focusing on technology, green energy, and financial services-saw a 3x increase in net inflows compared to FY24, according to a sectoral funds report.

Strategic Recommendations for Investors

For growth-driven investors, the key lies in balancing short-term volatility with long-term structural opportunities. Here are three actionable insights:

1. Prioritize Quality Over Momentum: Focus on sectors with strong earnings visibility and margin resilience. Financial services, infrastructure, and healthcare are prime candidates, given their alignment with India's demographic and policy-driven growth. For example, banking stocks benefit from a declining fiscal deficit and rising credit demand, as highlighted in an India equity market outlook.

2. Diversify Within Services: While the sector's growth has moderated, subsectors like fintech and digital infrastructure remain attractive. Mid-cap IT firms leveraging generative AI (GenAI) for cost optimization are gaining traction, according to a 2025 market outlook.

3. Leverage Domestic Strengths: India's equity market has become a haven for retail and institutional investors, with domestic flows offsetting foreign outflows. Systematic Investment Plans (SIPs) and thematic funds offer disciplined exposure to long-term trends like urbanization and digitalization, as described in a CFA Institute analysis.

The Road Ahead

India's services sector slowdown is not a collapse but a recalibration. With GDP growth projected at 6.4% for FY25-26 and a fiscal stimulus package announced in February 2025, per the TAC Economics outlook mentioned above, the economy remains on a growth trajectory. However, investors must remain agile, adjusting allocations to reflect evolving risks and opportunities.