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BFSI: Sell into the short-term rally

We see a short-term rally in Financials led by a potential deposit growth recovery as the RBI begins its easing cycle. Moreover, the sector remains an island of optically moderate valuations which is triggering a TINA factor for investors. We, however, believe this rally will not last beyond a quarter as margins come under pressure when repo rates are cut. Longer-term, we see lenders still overvalued, with fair-value ranges at 1.5-1.7x PBV vs current levels of 2-2.8x. This is a shortterm trade, and long-term investors should use this rally to lighten weightage.

Rate cycle set to turn

The 50bp cut from the Fed is likely to accelerate the RBI’s easing cycle. We believe that the RBI may have to move quicker than it wants, to prevent excessive upward pressure on the rupee which it can only partly mitigate by intervention. Importantly, the RBI is likely to shift to an accommodative stance with its first cut in Oct-24 or Dec-24, which could mark a decisive turn in domestic liquidity (Exhibit 3).

Benefiting from the liquidity turn

Easing of domestic liquidity has been a short-term powerful catalyst for lenders in the past (Exhibit 4), and we see this already starting to play out. This time, the impact is likely to be more pronounced because of the narrative of a deposit shortage. We believe the slump in deposit growth is entirely due to system liquidity as it tracks M3 growth very closely. We believe that deposit growth will bounce back as soon as the RBI reverses is stance, leading to a significant shift in sentiment for lenders. (Exhibits 3-6).

TINA factor

1YF Nifty PER is up 46% to 24x since Mar-23. This has pushed large parts of the market into overvalued territory. On the other hand, the PER for Financials has seen its discount to the Nifty PER expand, from 20% to 25% in the same period. IT is also the cheapest sector in the Nifty, barring energy. Lack of options for investors looking for reasonable valuations combined with the positive trigger of easier liquidity is pushing the short-term rally in Financials.

Key picks

We filter our universe on two criteria. Lenders with stretched funding benefit due to the pickup in deposit growth, while low mortgage exposures minimize the NIM damage. We choose HDFC Bank, IIB, RBL, and Shriram Finance as the key picks to play this short-term rally.

Sell into the rally

We see this as a short-lived rally. Rate cuts in 3QFY25 would lead to margin cuts in 4QFY25 for most major banks, given that mortgages (~30% of loan book for most large banks) reprice immediately. Also, banks may delay deposit rate cuts due to the recent tightness and HDFC Bank’s need to replace deposits of the erstwhile HDFC Ltd borrowings. Moreover, the structural adjustment to bank valuations is still WIP. We believe that with growth rates and ROEs in the mid-teens, the fair value for large banks is 1.5-1.7x PBV. Banks will continue to derate till they settle at these valuations.

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