As the US Fed has signalled that the rate hike trajectory will be longer than earlier expected, the debate over a looming recession in the US has gained momentum.
The US is the biggest economy in the world and a recession in the US will have a spillover effect across the globe. But analysts expect it will be more painful for Indian IT firms.
In fact, IT stocks have already been experiencing the heat of a looming recession in the US. The Nifty IT index is down 25 percent this year against a 6 percent gain in the benchmark Nifty50 as of December 15.
A long winter
Brokerage firm JM Financial sees a long winter ahead for the IT sector as it believes the demand for digital and cloud services, which seemed impregnable just a few quarters back, has started to cool off.
"Caution has crept into hyperscalers and SaaS players’ outlooks. Our checks suggest pessimism is highest in the UK, with almost all large deals off the table. In a likely scenario of an EU-centred recession, we draw lessons from the 2012 Eurozone crisis when IT Services demand turned sluggish for a protracted period – reflected in industry/Infosys consistently under-shooting their initial guidance in that phase," said JM Financial.
Though an EU crisis can trigger another wave of offshoring, as it did in 2012, JM Financial sees limited incremental share gains for Indian IT vendors.
JM Financial added that the revenue estimates of SaaS players have only now started to get cut as Covid-led tailwinds held up demand thus far.
The US and Europe are the major markets for Indian IT firms. In case a recession hits the West, Indian IT firms will be bound to experience pressure.
"As Indian IT service companies cater primarily for all global majors, a recession in the US or any slowdown in Europe has certainly direct impact on the business of these companies. Though most of the management is broadly maintaining their guidance for FY23, we expect a slowdown impact on business with lag effect and the first half of FY24 would see pressure on business and order wins," said Mitul Shah, Head of Research at Reliance Securities.
"There may not be cancellation of orders but execution ramp-up would be a slow and possible delay in new orders for the next one year. We believe that the IT sector with over 70-90 percent business coming from overseas, particularly the US and Europe, it can not remain immune to the global slowdown and its valuation multiple will remain under pressure over the near term," said Shah.
Should we stay away?
Analysts look convinced that this is not the right time to have exposure to IT stocks when there are domestic-oriented sectors for investment that can give healthy returns.
G Chokkalingam, Founder & Head of Research at Equinomics Research & Advisory, believes that IT may not be the best investment sector due to growth slowdown and a possible recession in the US.
However, Chokkalingam pointed out that valuations of this sector have contracted substantially and a steep fall in the rupee exchange rate will also help this sector to bargain better and pass on employee cost hikes to some extent in the medium term.
"Better option could be focusing on beaten down quality small and mid-cap IT stocks as the sector’s growth in dollar term is in poor single digits. Consolidation through acquisition is very much possible in this sector," said Chokkalingam.
Gaurav Dua, the head of capital market strategy at Sharekhan by BNP Paribas, is not optimistic about the IT sector.
"Despite the correction over the last couple of quarters, we continue to retain an underweight stance on IT services companies due to the risk of a downgrade in earning estimates in the coming quarterly result season," said Dua.
"Till now, the commentary on the demand outlook for most leading IT services companies has been quite optimistic. However, we expect it to turn a bit cautious now given the continued hawkish stance taken by the central bank in the US and the UK," Dua added.
Dua underscored that the fight against inflation continues to be the focal point of monetary policy despite the adverse impact of rate hikes on economic growth and possible recession in the year 2023.
"Despite the adverse impact of rate hikes on economic growth and possible recession in the year 2023, the fight against inflation continues to be the focal point of monetary policy and it is being reflected from senior management of leading global banks, retailers and manufacturing companies that form a large part of the client base for Indian IT services companies," said Dua.
Dua said one should be very selective in the IT services space and keep an investment horizon of a minimum of 12-18 months for meaningful returns.
Manish Chowdhury, Head of Research at Stoxbox, underscored though there is some comfort in terms of valuation in the Indian IT space, the ongoing global turmoil calls for a cautious and selective approach.
Chowdhury believes it would be difficult for companies to win large deals as global clients would focus more on cost reduction rather than replacing legacy systems. Additionally, the consultancy business of companies would largely take a hit as clients gear up to face the slowing growth.
"With market expectations building on the US entering into a recession in 2023, it would be better to wait for a quarter or two to let things settle and then take a staggered approach in stock picking," said Chowdhury.
Disclaimer: The views and recommendations given in this article are those of individual analysts and broking firms. These do not represent the views of MintGenie.