Oil production freeze, bank stress drag markets down

Saudi Arabia and Russia agree to freeze crude oil output at January 2016 levels

A combination of global and domestic developments dragged the benchmark indices down yet again on Tuesday, reversing most of Monday's gains.

The BSE Sensex fell 362 points on Tuesday, as Saudi Arabia, the world's largest producer of crude oil, and Russia agreed to freeze output at January levels and after the country's largest lender, State Bank of India (SBI), said bad loan accretion would accelerate in the March quarter.

Saurabh Mukherjea, chief executive officer - Institutional Equities at Ambit Capital, believes there is a high probability that the Sensex will hit 22,000 and it would take a minor miracle for markets to rally again, as there are far too many negatives in the world. What could change the tide is a serious attempt to recapitalise these banks.

Tuesday's biggest losers were mostly banks. SBI fell seven per cent, Bank of Baroda six per cent and Punjab National Bank around five per cent. Even globally, bank stocks are falling as risks of deflation appear to increase. Consumer Price Inflation across leading western counties is near zero and if the minor pick-up does not happen, then the sell-off in equities would accelerate.

In addition, a quarter of the world has negative nominal rates, symptomatic of weak economic growth. A deflationary world is disastrous for the banking system, as non-performing assets (NPAs) rise and loan books shrink. The outlook for India's state-owned banks appears particularly bleak after RBI's move to make them recognise bad loans. According to Morgan Stanley, bad loan formation numbers will rise and keep stock performance for corporate lenders in check.

Both these factors seem to be playing out in India. India's Wholesale Price Index continues to suggest the economy is in deflation mode and pain in the banking system is evident. Despite falling commodity prices, the Indian economy is not showing signs of accelerating. The Hope Rally has lost its legs as corporate earnings have failed to pick up and the oil bonanza has not helped revive demand.

Weak demand and falling corporate profits have accelerated the accretion of bad debt, as was evident from the December quarter numbers of Indian banks.

Dipen Shah, senior vice-president & head of Private Client Group Research, Kotak Securities, said: "Markets reversed a large part of Monday's gains on the back of renewed concerns over the banking sector. The fall came under pressure, despite the supporting global markets and higher crude prices. Four oil producing countries reached an agreement to freeze output at January 2016 levels, though the longevity of this agreement is not certain."

India's banking system is desperately in need of reforms and capital infusion. A strategist with a leading foreign brokerage says, "Even though the government keeps saying it will recapitalise, the market will not believe unless $20 billion (Rs 1.36 lakh crore) is infused into these banks."

Markets have been pricing in a global slowdown, as crude oil continued its downward journey. The agreement between Saudi Arabia and Russia to curtail output is also unlikely to impact prices in the near term.

In January, Saudi Arabia produced 10.2 million barrels a day, close to its peak of 10.5 million barrels a day in June 2015. The output cut, as a result, is unlikely to impact prices of crude oil, as demand remains sluggish. The International Energy Agency expects oil demand growth to ease to 1.2 million barrels a day in 2016 from a peak of 1.6 million barrels per day in 2015.

Stagnant earnings have only accentuated the risks of an economic slowdown.