Between January 1, 2020, and March 31, 2022, the Nifty IT index rose by approximately 144%, while the Nifty 50 index climbed by 44% and the Nifty Bank index improved by only 13%.
According to brokerage firm Nirmal Bang Equities Pvt Ltd, this enormous outperformance of Nifty IT was caused by pandemic-driven digital transformation (DT) services-based earnings acceleration and substantial multiple expansion on unprecedented monetary stimulus in the US/Europe.
Over the past 24 months, DT high tide has raised all boats including weak ones. However, the US's accelerated normalisation of monetary policy increases the likelihood of a hard landing there and, as a result, raises the likelihood of unfavourable fundamental shocks over the next 12 to 18 months.
"We believe consensus is underestimating growth and margin risks in FY24. While DT services will continue to remain a key theme for the next several years, we believe that ‘willingness-to-spend’ will be constrained by ‘ability-to-spend’ as enterprise customers battle earnings pressure from commodity and wage inflation, supply chain challenges, reduced consumer spending power, higher interest rates and likely below-trend growth in western developed economies," said the brokerage in its report.
According to the brokerage, this will mean that the S&P 500's present peak corporate profits are unlikely to last. It also thinks that the western economy's overall customer profit situation may be worse.
"Beyond FY23, we see customers shifting from the current democratic ‘skills/capability’ focused vendor model to a more discriminating one based on ‘ability-to-deliver’, " added Nirmal Bang.
Incrementally, risks are to the downside from both valuation as well as fundamental perspective. The brokerage favours Tier-1 IT companies versus Tier-2.
"We fear that the Indian Tier-2 set would suffer more because of vendor consolidation under the pressured profit picture for customers, a less diversified revenue mix, which could throw up negative growth surprises, and a larger exposure to non-Global 1000 clientele, whose profits are more vulnerable in the current macro environment," said the brokerage.
Although there is a possibility that the Fed will change course in the near future (due to likely financial/economic stress rather than lower inflation) and that this will lead to a run-up in risk assets, the brokerage continues to maintain an ‘Underweight’ stance on the Indian IT services sector.