Post Fed Rate cut can Financials be the new Defensive Play?

Much awaited and anticipated event of FOMC meet got concluded last night with Fed cutting more than expected 50 bps Fed rate cut with possibility of two more rate cuts of 25 bps till December 2024 and about 100 bps more in 2025. Rate cuts are viewed positively by equity markets as it has positive impact on Corporate Balance Sheets (albeit with some time lag) and for retail consumers.

However, all indices on the Wall Street ended marginally negative. More than expected rate cut by the Fed may be viewed as precursor to slowing economy and rising jobless claims – another precursor to expectations of recession round the corner. Practically, post all rate cuts by the Fed in the past, US economy has gone into recession as is shown by grey bar lines on the chart below:

However, rate cuts by Fed are positive for countries like India where funds flow into Emerging Market equities. This was evident in the Indian equity markets opening with a gap up of almost 700 points on Sensex 250 points on NIFTY (currently 211 up on Sensex and 30 on NIFTY at 1.30 pm IST). It is very difficult to find value in momentum driven bull market – as is the current situation. Many sectors and market caps are overstretched. Unfortunate part of the current bull market is that it is driven mainly by domestic liquidity in the system. Almost, 40,000 crores of inflows are entering Indian equities through retail & DII participation. That translates to almost 5 lacs crores of funds infusion in Indian equities. Though FIIs are net sellers YTD, they will start looking to invest in Emerging Markets (including India) once further rate cuts continue in 2024. We expect FIIs to come in to invest more aggressively post US elections in November.

Post most rate cuts and Fed pivot, history has shown that there have been recessions and major drawdowns in markets. In 2001, NIFTY fell 35%, in 2007, it went up initially to drop 60% thereafter in 2008. Currently domestic demand is soft and valuations are stretched. So far, Indian market rally has been broad based. All segments like Large, Mid and Small Caps have performed well. Now, it is time to be cautious and use a FUNNEL (Top Down) to filter where to invest. Also, there should be rotational change in both Market Caps and Sectors.

In the month of August, we had recommended adding Gold & Silver to investor portfolios to insulate them from oncoming volatility, slow down in economies and geo political tensions across various parts of the globe. Though it is very short period to compare, but that call has proved right so far:

Based on first filter, one should now invest in Large Caps and reduce exposures to Mid & Small Caps where valuations in many pockets are over stretched. Thereafter, second filter is to identify & avoid sectors which are stretched on valuations like autos, PSUs, industrial, metals and go overweight on those sectors which have so far not found investor fancy due to reasons mentioned below:

Generally, FIIs invest in Large and Mega cap stocks with higher liquidity and floating stocks. FIIs were over owned in the Financials and they had to cut their exposure in Financials due to lower weightage in the MSCI Index. One of the main reasons why Financials have not done well despite good earnings growth. So, within Large Caps, when benchmark weightage in Financials go up substantially by November, FII flows will happen in Financials once again. To find value in such an overheated market is to look at performance of some of the sectors which have done well on earnings but have not found investor fancy. Some such sectors and their performance since April 2021 are shown below:

As is visible from the above table, though there is very good earnings growth in NIFTY Bank, Financial Services, Private Banks and IT, there is derating which has happened in the Financials and Banking sectors with PEs on the negative side. This pocket has huge potential to be re-rated once FII flows start happening in the Emerging Markets post various rate cuts, US elections, higher weightage of Financials in MSCI EM Index. Also, India now has higher weightage than China in MSCI EM Index, which should attract more inflows. IT sector has also not performed well so far due to higher interest rates. Rate cuts will benefit this sector as well.

You can take advantage of cheap valuations of these sectors and upside going forward due to FII participation which will then fuel DII participation as well. This will be another step towards sector rotation from expensive to less fancied and reasonably valued sectors. This will ensure downside protection from market corrections (as and when that happens) when sectors which are stretched on valuations will have major drawdowns v/s sectors which are reasonably valued.