By Dhananjay Sinha, Co Head of Equities & Head of Research - Strategy & Economics at Systematix Group
The deepening underperformance of Indian banking sector stocks started in mid-December 2022 and was catalysed by various factors including a change in views on global liquidity, and more recently, the banking sector fiascos in the US and Europe.
Three important developments are pertinent here. First is the Hindenburg-Adani row, which brought to the fore the bafflement over the astronomical valuations of the group companies and the risk to bank lending.
Second, the eruption of the US banking crisis, and third, the sudden sharp weakening operating matrix of Indian non-finance companies in FY23 following the episodic post-Covid bounties, while the banking sector continued to etch an abnormal rise in profits. What the banking sector appears to be headed for is an assimilation of all these disequilibria.
It is now commonly understood that the series of US bank eruptions, starting with the collapse of Silicon Valley Bank, emanated in response to the abandonment of dithery by the US Federal Reserve towards a faster monetary policy normalisation as inflation accelerated to a 40-year high.
It is well known that monetary policy tightening works by deflating the prices of assets, including bonds, stocks, house prices, commodities, credit, and currencies. The first asset to be deflated is the treasury bond, followed by equities and others.
The banking sector implosion in the US is a fallout of deflation in treasury bond value due to the bear-flattening of the treasury yield curve in response to the 450 basis point Fed rate hikes. But this shift in the treasury yield curve has not happened suddenly – it has evolved over the past 1.5 years of the Fed’s normalisation.
The value erosion would have impacted multiple entities, including the Federal Reserve itself, which monetised almost $5 trillion of assets in the aftermath of the pandemic, investing funds and banks, foreign central banks that invested their forex reserves in dollar assets, and other entities. Thus, the treasury price erosion is an intended policy outcome and not an accidental effect.
Foreseeing the risk to the US banking system from asset price deflation, our research theme, “Markets are hasty in pricing in Fed’s leniency, (Moneycontrol, January ’23) emphasised the risk of a systemic solvency problem from further tightening by the Fed and asset price deflation.
It indicated the possibility that the financial stability of the US banking system would be tested due to asset price deflation emerging from the US house price boom followed by a bust, i.e., if the house price index were to correct by 20-25 percent. Since the full normalisation of the monetary policy has yet to pan out, the possibility of continued asset price deflation as part of monetary policy transmission remains.
At the current juncture, systemic liquidity in the US banking system remains in excess, estimated to be over $3 trillion, and asset price deflation hasn’t dented the net worth/disposable income ratio of households and non-profit organisations enough (currently at 7.7x) to tone down inflationary pressures.
In addition, despite the cumulative 450 bps rate hikes, US core Personal Consumption Expenditures and Consumer Price Index inflation remain high at 4.70 percent and 5.5 percent, respectively. This implies that the real Fed rate remains negative, far lower than the targeted 1.6 percent. Hence, the journey toward price stability is still halfway through.
While there is a general tendency to consider the Indian banking system to be immune to eruptions in the US, such insular views are tendentious. Here’s why:
Firstly, India was never immune to US tightening. The transmission of tightening global monetary policies has permeated into the Indian economy through multiple channels of slower growth and trade volumes, a diminishing forex buffer, slower money supply, rising interest rates, a weakening rupee, and structurally lower real GDP growth at sub-3 percent on a three-year CAGR basis. The economic growth slowdown is bound to impact the banking sector growth outlook – industrial lending growth has decelerated to 8.6 percent from a high of 13.6 percent in September 2022.
Secondly, the extended divergence between the worsening operating cash flow, the skyrocketing interest cost of non-finance companies, and the robust net interest income of banks is unsustainable. Our analysis of over 2,500 companies’ results till the December quarter shows a scaling down of operating variables across most sectors outside of the finance and IT sectors. These include sales, raw material consumption, operating profit, net income, and tax provisioning.
Hence, the divergence reflects the absorption of systemic stress by banks even as they scale down their asset quality exposure in search of higher yields. Thus, as the divergence capitulates, the banking sector will likely face the bane of cyclical convergence as non-finance companies concentrate on conserving margins rather than aiming for expansion.
The sharp deceleration in industrial loan growth could be a precursor. The contrasting trends of modest growth of 4.5 percent three-year CAGR in labour compensation of companies outside of finance and IT so far in FY23 amid persistently high inflation, and 18-20 percent growth in personal loans exemplify the potential retail credit risk.
Hence, the ephemeral bounty that banks gained from increasing lending growth, higher credit risks in retail lending, and elevated lending rates while limiting upward repricing of deposits will likely unwind. Going forward, the rising cost of funds, slackening credit growth, re-emergence of the non-performing asset cycle, and competitive pressures will likely dominate the performance in the banking sector.
The global transmission of monetary tightening will also induce downside risks to the valuations of banking stocks in India. The long-term trends of the Nifty Bank index suggest that during phases of economic slowdown, the P/B (TTM) valuation bottoms around 2.0-2.3x. Following the recent corrections, it has declined to 2.7x from 2.9x in December 2022.
In sum, as the global spill-overs of tightening liquidity, slowing growth, and asset price deflation pan out, it will be pertinent to consider the implications for Indian banks that confront structurally lower economic growth. With the post-Covid deluge of surplus liquidity drying up, the suppression of various risks – market, duration, liquidity, and credit cost – afforded by the deluge of regulatory forbearance will also come to the fore.
Thus, akin to other central banks, the Reserve Bank of India will also need to focus on counter-cyclical risks along with managing its primary objective of price stability.
Source: CMIE, Systematix Research
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