>Banking Sector (ANGEL BROKING)

Navigating the downturn

Since September 2008, the impact of the global crisis on India's GDP growth prospects has intensified through two channels - by dampening our exports and by reducing availability of finance. This slowdown in GDP growth poses material headwinds for the banking sector in the form of slowing credit demand and increasing asset quality pressures.

We believe that Monetary softening, strong Domestic Savings and falling Interest rates will help revive domestic demand from late FY2010E and subscribe to the view that stimulus packages and bank bailouts will stabilise developed economies over a similar timeframe. But uncertainty regarding the timing of the revival poses material risks for the Banking sector.

That said, after more than a year of falling stock prices, valuations for several banks are much below median levels. In our view, the sector is well placed to navigate the ongoing downturn and valuations provide substantial margin of safety against potential worst case scenarios of asset quality deterioration.

In order to draw conclusions regarding the course of revival of domestic demand and correspondingly, banking sector earnings, we have provided projections and analysis of financial savings, combined fiscal deficit as well as sources and deployment of funds by the banking sector. Underpinning our positive long-term outlook on the sector, is our view that long-term growth drivers for the sector continue to hold true (revisited in a recent report).

Concerns over asset quality and slowing credit growth will remain an overhang over both Private and PSU bank stocks so long as the macro-economic outlook remains bleak. Therefore, in our view, keeping in mind attractive valuations, a longer-term investment perspective needs to be adopted, in order to take advantage of the eventual upturn in GDP growth - and several factors are falling into place to make this imminent over the next 12-18 months.

From this perspective, we prefer private banks, in light of their stronger core competitiveness. Moreover, PSU banks carry the risk of government interference affecting their financial performance. Importantly, private banks are presently available at compellingly cheap valuations, based on historic trends as well as justified fundamental valuation multiples.

Our top picks are HDFC Bank and Axis Bank.

To see full report: BANKING SECTOR