Financials aren't falling because of fundamentals. It is because they are over-owned

Bank Nifty stocks, Bank Nifty, Financial sector, NBFCs, Bank stocks outlook

The Turkish lira slid 15% against the US dollar earlier this week after President Recep Erdogan defended a rate cut and vowed to win the “economic war of independence”. Last Thursday, Turkey’s central bank cut its policy rate by 100 bps to 15% and signalled that more easing would come by the end of the year. Rates have been slashed more than 400 bps since September 2021.

Erdogan is of the opinion that lower interest rates are the only way to curb inflation. Inflation stood at almost 20% in October, while food price inflation rose to 27%. Capital Economics, the London-based economic research consultancy, now predicts that “inflation is likely to rise to 25-30% in the next month or two” (2).

After a meeting with Erdogan, the central bank issued a statement saying the sell-off was “unrealistic and completely detached from economic fundamentals”. But the president blamed the lira’s weakness on “the games being played on foreign exchange and interest rates”.

Erdogan has fired three central bank governors in less than two years. More recently, he replaced the market-friendly Naci Agbal with Sahap Kavcioglu, a newspaper columnist who shares Erdogan’s view that high interest rates result in higher inflation.

Over the last five years, Turkish lira has stunningly slid from 3.5 to a US dollar to 12. More than 55% of all bank deposits in Turkey are now in foreign currency.

Sounds baffling, right? But a similar story has played out before.

After intense pressure during the Asian financial crisis, Indonesia’s currency was set to freely float in August 1997. By January 1998, its value was just 30% of what it was a few months ago. After three decades in rule, and years of mismanagement, President Suharto had to call the International Monetary Fund (IMF). A bailout package of $43 billion came with conditions — closure of private banks, winding down food and energy subsidies, and raising of rates by the central bank. After multiple rounds of failed implementation, the IMF broke down Suharto’s “patronage system” (where he doled out powerful positions in return for political patronage) (4). Eventually, after social and political protests, Suharto resigned in May 1998, after 32 years in rule.

In physics, the concept of self-organised criticality explains this well. All complex systems (like societies) naturally evolve, which leads to events that are good for the system’s performance. While mismanagement can last a few years, societies evolve to root out people that are bad for their countries.

Basically, what is not sustainable will find a way to not sustain — can be policies, economies, countries, politicians or markets.

Let us take the case of the Bank Nifty (BN), for example, which has over the last 22 trading sessions fallen 13%. BN reached an all-time high after the announcement of the stellar numbers from constituent banks. The weighted average (BN weights) net profit for September 2021 quarter rose 55% y-o-y and 40% q-o-q, driven by higher loan growth, rising margins and lower provisions. Commentary in conference calls regarding growth, creation of bad loans and overall outlook was positive across all the constituent banks.

Why the steep correction then, one might wonder? The obvious reason today is that Covid fear has resurfaced with the Omicron variant. But then, the BN had corrected over 10% even before this news. What gives?

First, of the 10 most over-owned companies by foreign institutional investors (FIIs) in India, six are financials. Over-ownership implies that the weight of these businesses in FIIs’ portfolio is higher than the weight of that respective company in an index. Other than State Bank of India, all the banks in the Bank Nifty Index are over-owned by FII.

Second, over the last two months, FIIs have sold close to $7.6 billion in Indian equities. Contrast that with the period of October to December 2020, when FIIs invested $17.2 billion. Bank Nifty rose 45% then. Or the period between January and March 2020, when FIIs withdrew $11.3 billion. Bank Nifty fell 40%.

Bank Nifty stocks, Bank Nifty, Financial sector, NBFCs, Bank stocks outlook

Covid’s role notwithstanding, the limited point is that when six of the 10 most over-owned businesses in FII portfolio are financials, they will be sold off when foreign investors withdraw investments. It is not a question of fundamentals – they were great, and the outlook was even better. It is a question of demand and supply. After all, investors can sell only the businesses they own.

But in equal measure, this provides an opportunity. During Covid wave 2, the BN corrected close to 18%, but subsequently rose 34% as fears subsided. Eventually, markets are slaves of earnings and demand-supply events are transitory. If the fundamentals of banks improve (meaning higher loan growth, stable margins, rising profits and reducing bad loans), which I think they will, then capital will eventually follow.

(The author is co-founder Buoyant Capital. Views expressed are personal.)

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