Winter has come but financial stocks may just dodge the cold

Financial stocks, in most times, have borne the brunt of broad meltdowns in equity markets and the past one week has been no different. Given that they are cyclical, they are in some ways a thermometer of the economy.

That explains why the Nifty Bank index dropped more than 3 percent today while the broader market slipped roughly 2 percent. The Nifty Financial Services index that includes insurance companies, and non-bank lenders too slipped about 3 percent.

The fast-spreading new covid-19 variant Omicron, the spectre of inflation and major central banks throttling back on their loose monetary policies have all contributed to the sharp fall in equity markets globally in recent times. Omicron has brought forth the risk of lockdowns which may potentially hurt a nascent global growth recovery and worsen an already disrupted supply chain. Indian equities cannot be immune to these which explains the past week’s pain.

It may sound counterintuitive to expect financials to buck this weak trend but analysts are forecasting them to perform well in 2022, perhaps even outperform broad market. “Valuations for financials seem reasonable with scope for further rerating as business conditions improve,” said Deepak Jasani, head of retail research at HDFC Securities in a note.

What may work for Indian financial stocks are two factors--- the turn in the interest rate cycle and the bad loan cycle.

The valuations of India’s lenders have been depressed mainly because of the unprecedented bad loan pile on their balance sheets. Banks have hacked away at this pile progressively over the past three years and dodgy loans are now down to about 9 percent of their balance sheets. While the pandemic had cast a cloud over bad loan management, it seems to be lifting now.

Historically, earnings of lenders have benefited during rising interest rate cycle. That is because lenders have swiftly passed on policy rate hikes by the RBI. At the same time, banks have managed to slow down the pass through to deposit rates, thus keeping their cost of funds from rising sharply and quickly.

Besides these, India’s economy is expected to grow by 9.5 percent in FY22, notwithstanding the threat from Omicron. Economic recovery, whether led by consumption or investment, leads to increase in credit demand and therefore gives a boost to earnings of lenders. Global brokerage firm Nomura’s business resumption index continues to show that the economic activity is gaining traction despite the threat of Omicron.

That said, there are potential upsetting factors too. While the Omicron threat looks muted so far, the impact of a slowdown in global economic activity would reflect in India’s output as well. That means that lenders could face headwinds in their bad loan recovery efforts. As such, small businesses have not been able to bounce back fast from the pandemic and could add to delinquencies for lenders.

But analysts expect these delinquencies to be overshadowed by the large recoveries in big legacy corporate bad loans for banks. The upshot is that financial stocks may look a lot healthier than the broad market going ahead. ​