Financials outperformed world over, but underperformed in India. Image Source: IANS News

New Delhi, May 26 : Despite quality names and an end to a multi-year painful credit cycle, financials have underperformed year-to-date (YTD) in India, possibly due to the uncertainty over economic normalisation due to the second wave of the Covid-19 pandemic.

As per a note by foreign brokerage CLSA, financials outperformed country benchmarks in 14 of the top-19 world markets YTD as investors view this sector as a great reflation trade.

"Despite quality names and an end to a multi-year painful credit cycle, financials have underperformed YTD in India, possibly due to the uncertainty over economic normalisation due to the second Covid-19 wave," the report said.

A recent peak in the wave should return investor focus to economic normalisation in the coming months, even as banks' relative valuations are below the historical average, and overweight of foreign institutional investors (FIIs) is at multi-year lows.

"We add Axis Bank to CLSA's India focus portfolio, replacing HCL Tech, as we reduce weight in defensives after their strong outperformance in the last two months. This 13-stock portfolio has outperformed the Nifty by 19 percentage point (ppt) YTD," the report said.

On an YTD basis, financials have been rank outperformers in most large markets in the world. Notably, MSCI World Financials has outperformed MSCI World by 12.5 ppt YTD.

The biggest outperformance of financials versus respective country benchmarks has been in Korea, the US, Japan and France.

Financials have beaten country benchmark MSCI indices YTD in 14 of the top 19 world markets. The report said investors view financials as one of the best reflation trades as economic growth recovers; this has been the core reason for outperformance.

India is one of the few markets, along with Germany, Hong Kong, South Africa and Brazil, where this trade has not worked.

Financials have underperformed MSCI India by 1.6 ppt YTD. This underperformance of financials in India may be seen as odd, since India has many high-quality, respected names in the sector. Moreover, Indian banks are coming out of a multi-year credit cycle, which should lower credit costs drastically.

The rising intensity of Covid 2.0 in India may have reduced investor confidence on India reflation trade outlook timing and made financials underperform, the report said.

A continued rise in vaccination should pave the way for gradual lockdown relaxation and eventual economic normalisation by August-September. These factors should again raise confidence on reflation trades.

Interestingly, the bank index bottomed within days of the first Covid-19 wave peak in September 2020 and it topped out within days of the bottom of active case numbers in February 2021, the report said.

Notably, this brief period of less than five months produced 40 ppt outperformance by banks. Despite coming out of a multi-year credit cycle, the banking index is only marginally above its long-term historical average passbook valuations.

The sector's relative valuation to Nifty is below the historical average discount at which it has traded. Overweight of FIIs in banks fell to a fresh multi-year low of 7.7 ppt in April 2021, which suggests one of the lightest FII positioning in the sector in many years. Overweight of even domestic mutual funds (MFs) in banks is much lower than in the heydays of 2019.

CLSA's defensive index has outperformed the Nifty by 3 ppt in the last two months, helped by strong performance of pharma and power sectors. After this, relative valuations of defensives are no longer as attractive.

"To accommodate Axis Bank and to make our portfolio more inclined to play the domestic reflation trade, we remove HCL Tech from our CLSA India focus portfolio. Other than banks, materials (Hindalco and Tata Steel) remain our big overweights, where we find record light positioning for domestic MFs and FIIs," the report said.

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