Underperformance, growth recovery likely to support banks' rally

Stronger balance sheets and little impact of digital disruption could be the other triggers

In the calendar year 2021, we saw the relative underperformance of banking. The Nifty50 gained around 26 per cent in the 12 months, and 2.7 per cent in December, while the Bank Nifty was up 16 per cent and 0.2 per cent, respectively. The Nifty50 has corrected around 10 per cent from its all-time highs; on the other hand, the Bank Nifty has corrected 19 per cent.

This is unusual. The banking sector has generally outperformed the broader market. Banks also have a large weighting in the Nifty50, with banking and financials contributing nearly 36 per cent to the Nifty weight. Applying contrarian investing logic, the underperformance makes it worthwhile, giving the banking sector a second look because it could revert to the norm of outperformance again.

The past six quarters have seen a benign interest rate cycle, with the RBI holding policy rates low (despite rising inflation) and taking other measures to ensure ample liquidity. Schemes like the Emergency Credit Line Guarantee Scheme have also supported banks.

In this period, corporate earnings have grown quickly across many sectors, driven by low base effects, tax cuts, and cost-cutting measures. As a result, there’s been a lot of deleveraging with corporates paying debt, and also better recovery of sticky loans. As a result, provision coverage ratios (PCR) have improved. Many, if not most, banks have stronger balance sheets and better non-performing asset (NPA) and provisioning coverage ratios than two years ago.

But in many segments across the listed corporate sector, top-lines have not yet bounced back to 2019-20 (pre-Covid levels), although profit margins have improved. Hence, banks have struggled with low credit growth, especially from the corporate sector, which has postponed capex plans. To some extent, lenders have been compensated due to increasing demand for retail credit, and also due to stronger growth in fee-based services. Digital disruption by fintech operators has not necessarily hurt conventional banks.

The market is still in the process of assessing the ongoing consolidation of PSU banks with its trend of mergers designed to create fewer, larger institutions. In theory, this should lead to lower costs, and stronger balance sheets. But full benefits of synergy may take longer to deliver. Some investors are also waiting for further disinvestment, which can mean a rise in the supply of PSB shares.

Could 2022 see a positive re-rating across the banking sector? If there is strong economic growth as anticipated, there should also be a rise in credit demand, especially from the corporate sector as new capex plans are augmented. Also, if revenues rise, there should be a continued trend of earnings growth, which should mean improvements on the NPA front.

In this optimistic scenario, banking should see a jump in credit growth, alongside improvements in NPA ratios, lower credit costs (as NPAs improve), and fewer new slippages. On the downside, the interest rate cycle is no longer so benign, and the RBI is likely to normalise in 2022 by tightening the money supply and raising rates if inflation remains persistent. That may hit net interest margins. The other downside risk is, of course, big waves of new Covid-19 variants, retarding growth.

The Bank Nifty dropped below its 200-day moving average in late December but now has jumped above that mark. The 200 DMA is taken to be a benchmark of long-term technical health and a drop below that normally signals bear markets. The quick recovery could, however, mean this was a false signal.