Will Banking Lead The Rally?

Even if the banking sector has witnessed a subdued performance in recent times, it seems well-positioned to lead the next market rally. With attractive valuations, improving liquidity and robust credit growth, banks may well emerge as the market’s flag-bearers 

Over the last five years, the Nifty 50 index has delivered significantly higher returns compared to the Bank Nifty. While Nifty 50 posted nearly 110 per cent returns, Bank Nifty managed to return only 74.6 per cent, underperforming the flagship index by a notable 35 per cent. 


 

However, recent trends show a shift in momentum. Over the past month, Bank Nifty has outperformed Nifty 50 by 132 basis points. Nifty 50 is down 5.95 per cent, while Bank Nifty has declined by a lesser 4.63 per cent. This raises two important questions: Why did banking stocks underperform? And, can banking stocks lead the next market rally? 

Why Did Banking Stocks Underperform? 

The underperformance of Bank Nifty can largely be attributed to HDFC Bank, which holds over 28 per cent weightage in the index. HDFC Bank faced headwinds due to its merger with HDFC Limited, which led to a sharp rise in its borrowings from 8 per cent to 21 per cent. This significantly impacted its cost of funds, which rose from 4 per cent to 4.8 per cent, and pushed its credit-to-deposit (CD) ratio from 87 per cent to 110 per cent. These factors weighed heavily on its stock performance. Moreover, public sector banks (PSUs) became more attractive to investors compared to private banks. 

While PSUs primarily serve institutional and corporate borrowers, private banks cater to retail credit needs. Despite strong credit off-take, private banks struggled due to their relatively high valuations. In a high-interest rate environment, value-conscious investors shifted focus to PSUs and the rally in PSUs further boosted the sentiment around PSU banks. However, PSUs hold only 15 per cent weight in Bank Nifty, limiting their positive impact on the index. Another factor that weighed on bank stocks was regulatory actions by the Reserve Bank of India (RBI). 

The RBI took measures such as restricting some banks from onboarding new clients and halting the issuance of new credit cards. These actions hit the stock prices of the banks directly impacted, and investors anticipated that other banks offering similar products could face similar scrutiny, making them more cautious. Moreover, banks have been struggling to attract deposits as customers have increasingly turned to financial markets for better returns. This shift has added further pressure on the banking sector, particularly in a scenario where deposits are critical for maintaining liquidity. 

How Are Banks Performing Now? 

The latest Q2FY25 results of major banks indicate better-thanexpected performance across the sector, with the exception of Kotak Mahindra Bank. HDFC Bank posted a 5 per cent yearon-year (YoY) rise in net profit, reaching ₹16,821 crore, primarily driven by a 10 per cent increase in its net interest income (NII) to ₹30,114 crore. Gross advances rose 7 per cent to ₹25.2 lakh crore, and deposits grew by 15 per cent to ₹25 lakh crore. The bank’s CD ratio is now close to 100 per cent and the management expects it to normalise to 86-87 per cent within 2-3 years. 

Axis Bank reported a 9 per cent YoY rise in NII to ₹13,483 crore, while net profit surged 18 per cent to ₹6,918 crore. The bank’s asset quality also improved, with gross NPAs falling by 29 basis points to 1.44 per cent and the net NPAs dropping by 2 basis points to 0.34 per cent. Kotak Mahindra Bank saw a more modest 4.8 per cent YoY increase in net profit to ₹3,344 crore with NII up by 11 per cent to ₹7,020 crore. However, its asset quality slightly worsened, with net NPAs rising by 6 basis points to 0.43 per cent. 

Union Bank delivered an impressive 34 per cent YoY jump in net profit, reaching ₹4,720 crore, beating market expectations. Its net interest income declined 0.9 per cent to ₹9,047 crore. But, the bank’s asset quality improved significantly, with gross NPAs dropping by 202 basis points YoY to 4.36 per cent and net NPAs improving by 32 basis points to 0.98 per cent. Across these banks, a common trend has been the decline in CASA (current account savings account) ratios as customers have increasingly favoured fixed deposits, anticipating a rate cut by the RBI. 

This shift towards fixed deposits (FDs) has affected the banks’ low-cost deposit base. Despite this, bank managements have indicated that liquidity conditions are starting to normalise, which is a positive sign for the sector going forward. As of October 23, most major banks, including both private and public sector ones, have reported strong Quarterly Results. The sector-wide challenges, such as liquidity constraints and slippages, appear to be subsiding. And there are signs that the withdrawal of obstacles may create new paths of growth for the banking sector. 

Conclusion
A key factor that could drive banking stocks higher is their current valuation comfort. Both private and PSU banks are trading at or below their historical valuations, which could attract investor interest, especially given the continued growth in credit demand and the improving asset quality across the board. Additionally, HDFC Bank is expected to see inflows of approximately USD 1.8 billion as part of the MSCI index rebalancing in November, which could further support the stock and the broader banking sector.

However, some key factors to monitor going forward include the timing of RBI’s interest rate cuts. While market consensus suggests a rate cut is unlikely in the December meeting, there is potential for a reduction in Q4FY25. The impact of this on credit growth will be critical. Furthermore, investors should closely watch how asset quality evolves, particularly in the unsecured lending segment, which has been experiencing some credit stress. These developments will significantly shape the banking sector’s future performance. 

Given these factors, the banking sector seems well-positioned to lead the next market rally. With attractive valuations, improving liquidity and robust credit growth, banking may indeed lead the next bull run, especially if HDFC Bank’s position strengthens post the MSCI rejig. However, investors should remain cautious and continue to monitor macroeconomic developments and regulatory actions that could influence the sector's growth trajectory. For the moment, keep an eye on the performance of individual banks and choose the one that displays good potential.