IT stocks are surging on hopes of a rate cut, but it’s too early to celebrate

The spotlight is on information technology stocks thanks to US Federal Reserve chairman Jerome Powell’s dovish comments at the Jackson Hole conference last week. Powell said the time has come for a monetary policy adjustment, hinting at long-awaited interest rate cuts. Powell did not reveal the quantum or the timing of the cuts, but expectations are that the US central bank will begin its easing cycle in September by trimming interest rates by 25 basis points. One basis point is 0.01%.

Signs of a turnaround in US monetary policy have boosted sentiment, pushing the Nifty IT Index up around 1.5% on Monday. Falling interest rates bode well for clients in the banking, financial services and insurance (BFSI) sector. The BFSI vertical is a crucial revenue generator for Indian IT firms, but elevated interest rates have caused companies to delay spending on discretionary IT projects. In recent quarters, BFSI companies have increased their thrust on insourcing and are investing in IT projects with immediate returns on investments. This has hurt the sector’s revenue growth visibility, leading to downgrades in earnings estimates, which have continued for FY25 and FY26 as well.

Green shoots emerge

Lower interest rates are expected to give BFSI companies a cushion to loosen their purse strings and increase their IT budgets. Some green shoots are already visible. After more than four quarters of a sequential decline in revenue, the BFSI vertical finally turned a corner in the June quarter (Q1FY25). On an aggregate basis, the BSFI vertical saw revenue rise by 1.3% sequentially for tier-1 IT companies in Q1, according to Motilal Oswal Financial Services.

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The commentary on this front is encouraging, especially for US BFSI. For instance, Tata Consultancy Services (TCS) management said BFSI clients are expected to increase spending on an integrated cloud model. Here, the nature of demand remains the same, with clients continuing to prioritise cost optimisation projects, management added. However, the US BFSI vertical grew more than its UK counterpart in Q1FY25. Infosys Ltd said the vertical returned to growth after six quarters due to the ramp-up of large deals and not one-offs.

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Some brokerages have also said recent discussions with clients point to increased traction in BFSI deals. Expectations are that pent-up demand in the BFSI sector will drive IT demand. But until meaningful revenue growth recovery takes place and there’s a sustained uptick in the BFSI vertical, sharp earnings upgrades are unlikely.

Large US banks remain cautious

It’s worth noting here that large US banks expect a gradual increase in technology investments from the second half of FY25. But for now they are cautious about investing in long-term IT transformation projects. According to Antique Stock Broking, the Q2CY24 results of six large US banks showed a marginal decline in technology investments. On average, technology spending as a percentage of sales fell to 6.3% in Q2CY24 from 6.5% in Q1CY24 and the past eight-quarter average of 6.8%. There are also lingering concerns around the upcoming US presidential election and fears of a recession in that country, so it’s best to keep expectations low.

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Despite earnings downgrades, the Nifty IT index is up around 17% so far in 2024, marginally ahead of the Nifty 50 index. However, valuations are rich and offer little respite right now. The Nifty IT is trading at a one-year forward price-to-earnings multiple of 29 times, a premium to its five-year average of 23%, said a Jefferies India report dated 23 August. “Furthermore, we see limited scope for positive surprises to consensus expectations of 7.5-8% USD revenue growth in FY26/27, as these have already baked in a pickup in discretionary spends,” it added.