Goldman Sachs on Thursday downgraded Indian markets to ?underweight? citing the Reserve Bank of India?s (RBI) liquidity tightening measures as one of the reasons, which have come at a time when the economy is experiencing sluggish growth, and could lead to fears of substantial foreign institutional investor (FII) outflows.

While the country?s economy had showed signs of recovery in the quarter ended March, recent data had been disappointing as there were no visible signs of a pick up in investment demand, said the American brokerage in a research note on Thursday.

Goldman Sachs observed that the macro-economic indicators such as index of industrial production (IIP) and purchasing managers index (PMI) for the manufacturing industry have been disappointing. The PMI in July stood at 50.1, indicating stagnation in manufacturing activity in India while IIP declined 1.6% in May. The central bank also slashed its FY14 GDP forecasts from 5.7% to 5.5%.

The brokerage said the Q1FY14 earnings highlighted ?weak investment demand and increasing cyclical pressures?.

The rupee which has weakened nearly 7% since June as FIIs pulled out nearly $3 billion from the equity markets continues to be a risk factor, according to Goldman. ?Although some of the foreign buying may potentially be from NRI?s through overseas subsidiaries, and hence arguably ?stickier?, the risk of outflows is still high as a weaker currency makes investment returns less attractive,? the brokerage added.

Meanwhile, overseas investors have withdrawn about $7 billion from the bond market since June. The outflow is almost equal to the size of inflows over the past one year.

The benchmark NSE index has shed 3% in the year-to-date amid deteriorating macro-economic indicators. The brokerage prefers pharma and IT stocks, is neutral on autos and negative on rate-sensitives like banking and real-estate. ?We favour IT, healthcare and energy sectors which may benefit from better external growth and have a meaningful portion of their revenues denominated in US dollars,? the brokerage said. ?Financials look most vulnerable to a potential ?flow reversal? given crowded foreign positioning,? it added.

CNX Pharma has gained more than 17% in the current calendar year, while CNX IT has gained more than 29% in the same period.