Edited excerpts from a chat:
What is the kind of base case scenario you are building in your calculations as far as rate cuts are concerned?
Our original thesis has been of a cumulative 50bps rate cut over the next six months starting with a 25bps cut in December of this year. Recent developments have added to our conviction in this view. Foremost, the space created by the US 50bps rate cut is undeniable. We also note RBI’s change in official stance from ‘withdrawal of accommodation’ to ‘neutral’ and its tolerance for greater overnight liquidity without concurrent OMOs to mop up.
Headline inflation in India also remains fairly benign with persistent inflation pockets like vegetable prices unlikely to be materially influenced by monetary policy. All in all, we see a high likelihood that a cut is coming.
Help us understand how the margins of banks will be affected when RBI starts cutting interest rates?
There is no denying that rate cuts drive an immediate pressure on bank margins as the asset side reprices a lot faster than the liability side. Significantly higher repo-linked loans on the balance sheet, in the form of mortgages and most prime corporate loans, ensure near instantaneous pricing adjustment. However, the immediate picture is not the full picture. Cuts also set the ground for benign bank margin expansion through FY26 from easing cost of funds and faster high-yield fixed-rate loan disbursements. Cost-of-fund benefits should be gradual, coming from FD repricing and higher CASA momentum (easier monetary and liquidity conditions). The only immediate relief is on short-term borrowing costs and for top-rated NBFCs on bank borrowings too (likely to be repo-linked).
Do you think in the beginning of the rate cut cycle, NBFCs would be better placed than banks?
Since the market narrative overwhelmingly sees rate cuts as a headwind for bank performance and thinks of NBFCs/NBFC-esque banks as the only beneficiaries on account of fixed-rate assets. Our analysis of the immediate impact of rate cut on lenders traces only the impact on fully elastic assets and liabilities (repo- or market-linked) and ignores belated benefits of FD repricing, increased CASA momentum or likely loan mix shift. Despite this, we estimate the immediate impact on earnings, whether negative for banks or positive for NBFCs, to be limited (3-6%) with very few exceptions.
What is the kind of earnings growth that you are baking in the earnings season for banks under your coverage?
2QFY25 should bring in the sense of late-cycle stability for most banks’ earnings profiles. Absent large credit-cost moves or sudden spikes in operating costs, the responsibility for beat/miss driven volatility in the last few quarters can be placed primarily at the feet of margins. In this backdrop, the sequential stability or limited fall in margins that we expect in 2QFY25 should provide comfort. This stability is on account of a FD (term deposit) book that has already repriced to market rates and some relief on short-term borrowing rates – a drop in CASA% is broadly neutralized at the margin level.
Similarly, system-level credit-deposit data and early releases from large banks suggest clearly that credit growth has slowed a bit while deposit growth has picked up a smidge (still FD dominant). This is the trend we had expected and should address fears of supply-side constraints on growth. In summary, we do not expect too many large surprises one way or another in this earnings season. This quarter should mark a near bottom on y-y earnings growth.
Given the underperformance, valuation and earnings growth momentum, do you think FY26 can be the year of largecap bank stocks?
Our prognosis is of benign margin expansion or, at the very least, stability in FY26 following a shallow bottom in late FY25 for large banks. Hence, strong credit growth should drive concurrent earnings growth momentum in FY26 – a key re-rating catalyst in our view and set up potential strong performance for banks. In banks, HDFC Bank, ICICI Bank and Axis Bank remain our top picks – in that order. Kotak Mahindra and City Union Bank remain underperform.
HDFC Bank is your top pick in banks ahead of ICICI Bank. Do you think that HDFC Bank can outperform ICICI Bank and why?
HDFC Bank has more re-rating potential than ICICI Bank at current prices, quite simply because the latter’s strong performance has moved multiples relatively closer to what we see as steady-state than in the case of HDFC Bank.
HDFC Bank is actually a counterintuitive beneficiary of easing. Given HDFCB’s low-CASA, mortgage-heavy post-merger balance sheet, the understandable reflex is to see rate cuts as a serious headwind. HDFCB specifically has the additional tailwinds in its margin journey of expiries of higher-cost NCDs/FDs that it inherited from its parent entity. As RoAs gradually cover back towards 2% at a slow pace, market is likely to realise that a valuation of 2.1x 1-year forward core BVPS (30-40% discount to long-term average) does scarce justice to an FY27E core ROE of 16.5% that compares favourably with its pre-merger past five-year average of 17%.