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Risks receding and growth cycle to strengthen

Cleaner balance sheets to meet abundant liquidity: After navigating nearly twoand-a-half years of asset-quality challenges across multiple retail lending segments, NBFCs are entering FY27 with cleaner balance sheets and improving growth visibility. With macro risks receding and banking system liquidity poised to improve, we believe the sector is well positioned to enter the next growth cycle from a position of fundamental strength

The macro narrative has flipped; crude correction removes a key tail risk: The escalation in US-Iran hostilities and the spike in crude oil prices had materially altered the risk-reward for NBFCs by raising concerns around inflation, policy rate hikes and pressure on borrower cash flows. The subsequent peace agreement and a correction in crude prices have significantly diminished these risks. We now expect a broadly stable interest rate environment, while risks to the cash flow of commercial vehicle (CV) operators and MSMEs have also receded

Liquidity could emerge as the next big catalyst for growth and margins: The key challenge for NBFCs over the past two quarters was not the availability of liquidity, but its price. Incremental borrowing costs continued to inch higher for most NBFCs and HFCs despite an easing policy rate environment. The impending liquidity influx into the banking system through FCNR(B) deposits could alter this dynamic. As banks look to efficiently deploy surplus liquidity, we expect NBFCs to benefit from improved funding availability, stronger negotiating power and a gradual moderation in incremental borrowing costs

The trifecta is turning favorable – growth, margins and asset quality: We believe FY27 could mark the beginning of a broad-based earnings uptrend for NBFCs. Cleaner balance sheets and improving liquidity should support stronger loan growth; stable interest rates and moderating incremental borrowing costs should provide margin visibility; and normalizing asset quality should result in benign credit costs. Our 1QFY27 preview suggests that NBFCs are starting the year on a strong footing across all three earnings drivers.

Why this liquidity cycle could be different: Historically, periods of abundant liquidity have translated into stronger growth for NBFCs. We expect the same dynamic to play out again. However, the key difference this time is that NBFCs are entering the liquidity cycle after nearly two-and-a-half years of risk recalibration, tighter underwriting and balance-sheet clean-up. We consequently expect the next phase of growth to be supported by significantly stronger fundamentals.

Prefer diversified lenders and selective cyclical recovery plays: Within the sector, we prefer diversified lenders that can dynamically allocate capital across products and benefit from improving liquidity and accelerating credit growth. We also see opportunities to play the cyclical recovery in microfinance and micro-LAP. Our preferred picks are Shriram Finance (SHFL), L&T Finance (LTF), Five-Star Business Finance and PNB Housing Finance (PNBHF). Key risks to our thesis are a weak monsoon and a potential re-escalation of geopolitical tensions in West Asia

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