Banks - Sifting through macro signals

A virtuous cycle of lower lending rates, lower fiscal deficit and higher economic growth has propped up the banking economic system in the past few years. The benign economic environment now appears to be under threat. We believe valuations reflect the threat. Buy Axis Bank, ICICI Bank, Canara Bank and Power Finance Corp.

Virtuous growth cycle appears to be under threat
In the past couple of years, absolute fiscal deficit has been significantly lower than nominal GDP growth, which has boosted private participation in the economy. Private savings and investments have risen, underpinning economic growth. This has resulted in buoyant tax revenues, hence falling fiscal deficits. We believe this scenario is now under threat with rising fiscal deficit and slowing economic growth. Unlike in the past, the fiscal slippage and the increase in government borrowings are coinciding with high credit demand from the private sector. We also see pressure on domestic liquidity from a sharp moderation in balance of payments surplus.

Bulls may argue the interest-rate cycle has peaked or is close to doing so
We see some merit to the bull argument. However, loan growth, money supply and inflation are running ahead of the targets set by the Reserve Bank of India (RBI). Our economics team sees the possibility of another 25-50bp hike each in the cash reserve ratio and the repo rate over the next six months. Both lending and deposit rates have increased sharply in the past couple of months, and may have to be raised further to accommodate further tightening. The pass-through effect of the rate hikes on loan growth and asset quality should be seen in the next six to 12 months.

Banks appear unscathed so far
We believe net interest margins will remain under pressure and mark-to-market losses may rise. However, other levers, such as fee income growth and expense control, should partly offset challenges on the margin front. Asset quality remains healthy due partly to the diversified loan books of banks, while profitability is unlikely to slip sharply.

Valuations seem to reflect concerns; select stocks look attractive
The long-term attractiveness of the Indian economy and the banking industry remains intact, in ourc view. Near term, we believe the changes in the macro environment are reflected in sector valuations. We maintain Buy on Axis Bank, ICICI Bank, Canara Bank and Power Finance Corporation. We advise investors to Buy HDFC Ltd on dips.