Bear Case Firmly in Play
Banks have lagged index by 11% since first RBI action. Should we buy / sell now - there maybe rallies but we would sell these. Macro is unwinding; we believe next 3-4 quarters will see sharp spikes in impairments (slowing growth and higher rates). Sharp rate decline is the bull case.
Increased probability of bear case for Indian banks: Recent rate move is likely to lift defaults on loans over the next 6-12 months. Interest rates (3 month CP) are now up ~300bp over July, and with continued currency depreciation, are likely to stay elevated. With growth slowing, the pressure on profitability will go up. We have reduced our bear cases meaningfully and increased the probability of our bear case in our weightings.
Corporate leverage at decadal high: This has caused a sharp increase in impaired loans. Currency depreciation will also hurt given that corporate external debt is ~ US$225bn and about 50-60% is unhedged. Hence, pace of bad loan creation will jump (we expect impaired loans to increase to 12% by F2015 in our base case and 15.5% our in bear case from 9.2% currently).
Loan growth likely to fall to ~10%: Demand is likely to drop given slowing growth. As well, most big borrowers over the last 3-4 years are struggling with existing debt (and unable to borrow). SOE banks (75% of system) will likely struggle given lack of capital (net impaired loans at some larger banks are now more than equity).
We would stay away from corporate lenders: Given the likely increase in impaired loans, corporate lenders will likely struggle. Wholesale funded banks should also lag given the spike in funding costs. Our top picks remain HDFC Bank and HDFC. We would avoid Axis, SBI, and PNB.
Where we could be wrong: If growth picks up or interest rates come off, underlying fundamentals will improve. The stocks to own if macro improves would be Yes and IIB given leverage to rate and growth cycle.
Increased probability of bear case for Indian banks: Recent rate move is likely to lift defaults on loans over the next 6-12 months. Interest rates (3 month CP) are now up ~300bp over July, and with continued currency depreciation, are likely to stay elevated. With growth slowing, the pressure on profitability will go up. We have reduced our bear cases meaningfully and increased the probability of our bear case in our weightings.
Corporate leverage at decadal high: This has caused a sharp increase in impaired loans. Currency depreciation will also hurt given that corporate external debt is ~ US$225bn and about 50-60% is unhedged. Hence, pace of bad loan creation will jump (we expect impaired loans to increase to 12% by F2015 in our base case and 15.5% our in bear case from 9.2% currently).
Loan growth likely to fall to ~10%: Demand is likely to drop given slowing growth. As well, most big borrowers over the last 3-4 years are struggling with existing debt (and unable to borrow). SOE banks (75% of system) will likely struggle given lack of capital (net impaired loans at some larger banks are now more than equity).
We would stay away from corporate lenders: Given the likely increase in impaired loans, corporate lenders will likely struggle. Wholesale funded banks should also lag given the spike in funding costs. Our top picks remain HDFC Bank and HDFC. We would avoid Axis, SBI, and PNB.
Where we could be wrong: If growth picks up or interest rates come off, underlying fundamentals will improve. The stocks to own if macro improves would be Yes and IIB given leverage to rate and growth cycle.
Investment Case
RBI tightening at a time of slowing growth is likely to spell
trouble for banks’ asset quality – Impaired loans for the
sector had already increased from 5.4% in F2010 to around
9.2% in F2013. The move by RBI will cause a sharp pickup.
With currency continuing to depreciate, we don’t expect a quick
reversal by RBI on recent tightening moves.
Our framework of asset quality shows potentially deep
stress for banks – We look at GDP growth – rates as a good
indicator of banks asset quality. This has been stable for the
last 12 months (at low levels). However, the recent slowdown in
growth and increase in rates has caused this indicator to move
into negative territory. We expect impaired loans to increase to
12% by F2015 in our base case and 15.5% in our bear case.
Corporate profitability is low – The interest coverage at BSE
500 companies is at the lowest level since early 2000’s. Recent
rate hike will likely take this lower. With very weak corporate
balance sheets evident in sharply deteriorating debt to market
capitalization, we expect a significant pickup in impaired loan
formation.
Loan growth likely to trend to single digits – We expect a
slowdown in demand for loans given the weak macro.
Moreover, all the big borrowers of the last few years are now
struggling with existing debt. Among banks, SOE banks (75%
of system) will struggle to grow given the weakness in balance
sheets – net impaired loans at many of these lenders is now ~
100% of equity. We expect continued strength in consumer
loans in F2014 but even this will slow in F2015.
Changing price targets meaningfully – We are downgrading
IIB to EW from OW, and Union, BOI and Shriram to UW from
EW. We are also materially cutting our price targets due to
earnings revisions, lower fair values in bear case and
increasing probability of bear case. We continue to like HDFC
Bank (though 30% EPS growth is unlikely to recur in F2015)
and HDFC given retail lending. We remain OW on ICICI Bank
too despite large corporate loans as mix is shifting towards
retail.
If the macro turns, the stocks to own would be some of the
smaller private lenders – This is primarily Yes Bank and
IndusInd. The stocks are trading at very attractive multiples as
investors are concerned about funding costs and potential
losses on assets (NPL’s or bad loans). If the macro improves,
we could see a sharp pickup in these stocks.
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