Bank Nifty versus Nifty IT: Which one will outperform the peer in medium to long term?

A Sneak Peek into the Past

Banking and IT are the two critical domestic sectors, constituting around 34 percent and 14 percent of the Nifty50 index. Though both the Bank Nifty and Nifty IT indices have outperformed the benchmark index on the last 10 years returns basis, the Nifty IT has generated superior returns over Bank Nifty over a ten-year horizon, with their performances being volatile at best. From an investor perspective, the right allocation to these sectors is critical in generating alpha in the portfolio.

Historical Performance: Nifty, Bank Nifty and Nifty IT Indices

What Lies Ahead for These Heavyweight Sectors?

In the pandemic years, the outperformance in Nifty IT versus Nifty and Bank Nifty was primarily driven by a sharp acceleration in earnings due to COVID-driven digital transformation services. However, the challenging macroeconomic environment in the US and Europe due to the rising interest rates coupled with concerns surrounding the banking industry (Credit Suisse and a few US regional banks) has clouded the near-term demand outlook for the sector.

The IT-related discretionary spend is expected to take a backseat for at least the next one-two quarters till some clarity emerges on the banking crisis and macroeconomic fallout. It should be noted that the BFSI segment contributes about 30 percent to the overall IT revenues. Against the prevalent IT spending uncertainty, we expect an elongated decision-making cycle from the clients, a delay in project starts, and lower deal sizes as we move forward from hereon.

We believe that companies would focus on cost optimization and vendor consolidation-related spending in the next few quarters. This should ideally benefit largecap companies versus midcaps as the former are in an advantageous position over the latter due to their sheer economies of scale, multi-vertical exposure, a larger share in the global Fortune 500 accounts, higher client stickiness, deeper domain know-how, and strong execution capabilities.

The impeccable performance of the IT sector since the COVID-19 crisis has seen robust growth in the topline which we believe would moderate as we move forward. However, IT companies would be able to navigate these difficult times and protect or even better their margin profile due to a slowdown in hiring, easing attrition rates, higher utilization rates, lower sub-contractor costs, and normalization in salary costs.

We believe that IT companies are better placed to meet incremental demand this time around as they have front-loaded their hiring in the earlier quarters. With expectations of lower turbulence in the macro environment towards the end of the year, we believe that the overall texture for the IT sector should improve from thereon.

Moving on to the banking sector, the key highlight of the past few quarters was the healthy loan growth (up 15 percent YoY) which was driven by an all-around performance from retail, SME, home, vehicle, and unsecured segments. We believe that a pick-up in the private capex from the corporate segment will be a key monitorable for the sustenance of this credit growth in the future.

However, a difficult macroeconomic situation emanating from the high inflation and resulting in the RBI raising interest rates could prove to be a major dampener for the banking sector going forward. We believe that NIMs (net interest margin) had majorly benefited due to the lag effect in passing interest rates between the loan book and deposits. This should ideally narrow as more banks race ahead to garner a larger chunk of the low-rate deposit base, with severe deterioration in NIMs being ruled out due to strong credit growth and continuous re-pricing of the floating rate book.

We are already witnessing a pickup in deposits, with some financial sector stocks even reporting a higher deposit growth vis-à-vis credit growth in their Q4FY23 business updates. Moreover, we do not foresee any major stress in the asset quality of the banking sector due to adequate provisioning and expect slippages to remain under control. With the retail side of the equation looking good, we believe that the performance of restructured, MSME and ECLGS (emergency credit line guarantee scheme) books would be closely monitored by the street for any early signals of deterioration in the asset quality.

We feel that banks with good liability franchises, granular balance sheets, and robust underwriting have an edge to manage both the funding cost and slippages in a rising interest rate regime.

In a Nutshell - The Final Say

It should be noted that the structural demand drivers for the IT sector are in place and we should expect the demand dynamics to change for the better from Q3FY24. We believe that the current valuation of the IT sector, which has corrected significantly from its peaks, has already factored in concerns related to the macroeconomy and banking crisis. However, it is still trading at a premium to its long-term average.

Any further correction from these levels due to panic selling should ideally be an opportunity to build a robust portfolio across blue-chips such as TCS, Infosys, and Tech Mahindra. We advise investors to prefer Tier-1 IT companies over Tier-2 as the current vulnerable macro environment would see the valuation premium of Tier-2 companies shrink going forward.

Historical Nifty IT P/E Multiple Trend

On the banking side, we expect at least the next two quarters to be robust, owing to strong credit growth, record margin profile, benign credit costs, and stable asset quality. However, we believe that it would take some heavy lifting by the banking majors to sustain this record performance, especially considering the high base.

We believe that rising deposit costs, liquidity tightening, and elevated operating costs would keep their performance under check. On the valuation front, Bank Nifty offers more comfort compared to Nifty IT at this point. We continue to like ICICI Bank in the large private banking space, SBI in PSBs, and Equitas Small Finance in the midcap banking sector.

Historical Bank Nifty P/B Multiple Trend

In a nutshell, we believe that Bank Nifty should outperform Nifty IT in the short-to-medium term, while Nifty IT has an edge over its banking counterpart in the longer-term timeframe.Disclaimer: The views and investment tips expressed by investment experts on Moneycontrol.com are their own and not those of the website or its management. Moneycontrol.com advises users to check with certified experts before taking any investment decisions.