Stay defensives in near term for banking space: Angel

Angel Broking's research report on banking sector

Asset quality stress has remained at elevated levels for banks, thereby denting sector’s performance and outlook. Until 4QFY2013, there were signs of moderation in pace of asset quality deterioration, as the increase in annualized slippage ratio for overall FY2013 came in 26bp yoy, much lower than the increase of 38bp and 57bp yoy witnessed in 9MFY2013 and 1HFY2013, respectively. In 1QFY2014, asset quality woes intensified, as annualized slippage rate surged to 3.7 percent, a much higher increase of 63bp yoy. Elevated slippages coupled with moderate performance on the recoveries and upgrades front, resulted in sharp 16.8 percent qoq increase in Gross NPA levels for our coverage PSU banks, while the increase was moderate for our coverage Pvt. banks at 5.4 percent.

Until a couple of months back, lower inflation was expected to be a big positive catalyst for the economy, as it would have eventually led to lower rates, improvement in growth, higher savings and investments mobilization, improved asset quality outlook and higher MTM gains. However, recent series of RBI measures to tighten domestic liquidity so as to check exchange rate volatility, has effectively made our monitory policy movement tied to Federal Reserve moves and has led to significant surge in interest rates across the yield curve, which has put a clear hurdle in lower inflation catalyst playing out. Tough time to continue for Indian Banks: Given RBI’s policy tightening measures to check USD-INR volatility, macro environment is expected to remain challenging in near term and elevated interest rates and slower growth appears inevitable now. Credit growth for the banking sector is expected to reduce from the levels envisaged earlier. Asset quality outlook also remain tough, as apart from continued elevated level of slippages, higher restructuring and increased slippages from restructured book can be expected. Though the quantum of MTM losses has reduced post the RBI relaxation on transfer within book, the outlook on bond prices still has a downward bias and hence MTM losses would remain meaningful, so as to affect overall earnings.

Outlook and Valuation: Elevated interest rates, weakening growth, and a volatile currency would ensure that the earnings pressures for Indian banks will increase here on. PSU banks, apart from the cyclical headwinds mentioned above, also face structural challenges in terms of a) low capital adequacy (for many of them; which increases the risk of book dilutive capital raising and hurt growth prospects), and b) higher competitive intensity (not only loss of deposits and credit market share, but also of profitability - as current credit cycle evidently highlights adverse asset selection on part of PSUs and superior selection by private banks in the past, which is reflecting in their performance now). Although valuations for all of them are below their historic lows, their fundamental investment case appears weak enough to avoid them, until clarity emerges on macro front. Overall, we have a cautious stance on the sector and would recommend staying with the defensives in the near term. After the recent correction in prices, HDFC Bank becomes a Buy for us. We like ICICI Bank and Axis Bank, which in our view, offers value over a medium to long term perspective, though we do not rule the possibilities of these stocks undershooting the fair value estimates in the near term, given the fragile macro environment.

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