Bank vs IT stocks: Domestic fund managers face a 'Hobson's choice'

Backing the right pack can help in alpha generation, as the two often move contrarily

Choosing between banks and information technology (IT) stocks could be the toughest choice facing domestic fund managers and the biggest factor behind alpha generation. Both sectors have a considerable weighting in the benchmark National Stock Exchange Nifty50 Index, are the largest contributors to India’s market capitalisation, and are hence pivotal to any India portfolio. 

However, both move in opposite directions 70 per cent of the time.

“Put together, financials and IT account for about 40 per cent of Morgan Stanley Capital International India and 50 per cent of Nifty. Our analysis of the performance of the Nifty IT and the Nifty Bank since 2010 shows that the two indices tend to generally move in opposite directions. Compared to the Nifty, on a trailing three-month or six-month basis, the relative performance of the IT index and the bank index has been in the opposite direction 76 per cent and 70 per cent of the time, respectively. Even if we consider longer periods, say one/two years, the opposite performance sustains for more than 60 per cent of the time,” observe Jefferies equity strategists Mahesh Nandurkar, Abhinav Sinha, and Nishant Poddar in a note.

In other words, choosing the right pack at the right time can help one beat the market by a wide margin.

Fund managers that operate large-cap equity portfolios do not entirely ignore marquee sectors like financials and IT. 

They are typically underweight or overweight in these sectors at any given point in time vis-a-vis their weightings in the Nifty50 or the Nifty 100 indices.

What explains the divergent performance of IT and banks?

“The fundamental reason is that banks tend to outperform during times of favourable macroeconomic (macro) conditions like a stable or strong rupee, falling yields, and strong growth. While IT tends to outperform during weaker macros, rising yields or inflation, and a weakening rupee,” explains the trio at Jefferies.

“The business models of the two sectors are diametrically opposite. IT is largely dependent on business outside the country, and the fortunes of finance companies are tied to the domestic economy,” says Chokkalingam G, founder, Equinomics Research & Advisory.

The Indian market is currently undergoing a similar phase of variant performance, with banks in the lead.

Between February and June, banks have outperformed the Nifty50 by 3.7 percentage point (ppt), while the IT index has lagged the benchmark by a staggering 12.9 ppt.

The IT sector’s underperformance follows a period of sharp outperformance between September 2022 and February 2023. During this period, the IT pack outperformed the Nifty by over 15 ppt, while the banking sector underperformed by 2 ppt.

Between 2010 and 2023, there are seven/eight distinguished periods when either banks or IT have underperformed or outperformed vis-a-vis the Nifty. There have been only one or two occasions when both have moved in tandem.

In the latest cycle, banking sector bulls have made money, while IT backers are licking their wounds.

Will the tide turn anytime soon?

Jefferies believes there is still more steam left in the banking sector’s outperformance.

“Empirically, this type of trend usually lasts for three quarters. We are just halfway into it currently. We would be sellers into the recent IT rally,” say Nandurkar, Sinha, and Poddar.

“Domestic gross domestic product growth is expected to be higher. India might be one of the world’s fastest-growing economies this financial year. Hence, the banking sector will continue to do well. Whereas there is a slowdown in the US, IT will suffer,” observes Chokkalingam.

The strong gains in banking stocks are underpinned by expectations of a new private capital expenditure (capex) cycle.

“The banking sector has seen strong performance in 2022-23 (FY23) as system-wide loan growth at 16 per cent was at a multi-year high. Moreover, asset quality is benign, and the fast transmission of rate hikes has helped to widen net interest margins. The outlook for the sector is strong, with 12-14 per cent sector loan growth (and even higher for the private sector at 18-20 per cent) likely in 2023-24 (FY24), partly as India starts seeing a new private capex cycle (both housing and private corporate capex in an upturn),” reads the note by Jefferies.

Meanwhile, IT companies are currently on a sticky wicket.

“IT outsourcing demand has weakened substantially in 2023, with several technology majors reporting flat to declining revenues in the fourth quarter of FY23. The outlook is weak as well, with mid-single-digit growth guidance and no increase in employee headcounts planned in FY24. Despite the weak outlook, IT companies’ valuations are still above historical averages. The current period of banks outperforming still has a long way to go,” adds the note.