Time to bet on a recovery in bank stocks

There could be a big bounce in the third or fourth quarter of this financial year, which would boost the indices

The RBI maintained the status quo, or nearly so, in its June credit policy review. The central bank did not change rates but it did ease the SLR (Statutory Liquidity Ratio), which releases some cash for commercial lending.

The RBI also updated estimates for inflation and growth. The central bank expects inflation (as measured by the consumer price index) to hit 8 per cent by January 2015 and to decrease to 6 per cent by January 2016. If inflation moves as projected, real GDP growth should be somewhere between five and six per cent in 2014-15. Inflation projections remain the same and growth projections are within the same band as before. At best, the RBI seems to expect that growth will come in at the higher end of the band.

These projections make it clear that the central bank isn't quite as sanguine as the average entrepreneur about the pace of economic recovery. Arguably, it is already very close to the first inflation target of 8 per cent, with inflation in April at about 8.6 per cent But this is just a point-to-point number and the direction of inflation trends is important. This is why the RBI governor keeps talking about the "glide path of inflation".

If there is a good monsoon and food inflation moves lower, the 8 per cent target could be met, maybe with months to spare. However, a poor monsoon could lead to higher inflation. So could a sudden spike in crude oil prices, or even the scheduled increase in natural gas prices.

The Budget will provide a critical series of inputs when it comes to judging the likely inflation trajectory. Will the Budget be growth-oriented? Or reform-oriented? The two are not necessarily the same - a reform-oriented Budget may set the stage for sustained long-term growth without immediate acceleration.

Will the Budget pay heed to the fiscal situation and try to reduce government deficits? Growth, if it comes along with a high fiscal deficit, could be inflationary. More broadly, since this Budget is the first major policy document coming from a new government, it would give indications as to the long-term economic direction over the next five years. The central bank will assess that before planning the next steps in its long-term strategy.

Is the RBI likely to start cutting rates in a post-Budget scenario? I don't think this is likely to happen until the trends of Q2 are known. However, barring a very poor monsoon, or some other highly inflationary factor, the RBI is very unlikely to raise rates again during calendar 2014. More likely, cuts are on the cards.

The RBI also has to take a call on where the global economy is going. As things stand, the US and the UK seem to be in recovery while the EU has seen weak growth. China is in the middle of weak growth with a potential banking crisis on the horizon. Japan could be critical - the economy is showing some signs of growth after decades of recession. On the external front, India's trade balance and the current account deficit are manageable and the situation has improved quite a bit.

An interesting point is that the RBI has allowed FIIs to play the domestic currency derivatives market with a limit of the respective underlying exposure plus $10 million. This should lead to more liquidity in an already liquid futures market and could provide a boost to the options segment.

The banking sector in India is hoping for better times after two years of deepening recession. The last fiscal saw record NPAs and record restructuring requests. Interest rates and liquidity remain tight. The RBI has extended its timelines for Basel-III compliance. But there is some consensus that corporate earnings will improve this fiscal.

If the NDA can restart various stalled infrastructure projects, the situation with respect to NPAs will also improve on that front. However, this is more of a medium-term pick-up since infra projects tend to have long gestation periods.

Chances are good that bank results will show some improvement through 2014-15 and there could be a big bounce in Q4, or perhaps in Q3. A lot of investors will be gambling on a broad recovery across banking. It has a huge weight in the major stock indices and the listed economy.