The stress in the US banking system has created significant short-term risks for the equity markets. The timely and aggressive intervention by the Fed and the Treasury is likely to contain the damage but markets could, nevertheless, remain in risk-off mode for some time. This would mean that flows to emerging markets like India would remain stressed and the broader Nifty likely to remain under pressure. A sharp market sell-off is the worst-case and unlikely scenario – even if it does materialise, we expect global central bank intervention to fuel a quick recovery.

US Banking Crisis
The sharp hikes by Fed since early 2022 have left some banks with large losses on the bond portfolio. The issue gained prominence after Silicon Valley Bank (SVB) announced large losses that eroded its capital base. This led to a flight of deposits, initially from SVB, which has since spread to other mid-size and regional banks.

A silver lining is that the core of the problem is asset-liability mismatch rather than credit issues. This implies that losses are somewhat transient and, moreover, are backed by near sovereign securities. It is, therefore, easier for governments and central banks to provide liquidity against these assets. The deposit flight amplifies the crisis, but still makes it manageable. The other positive is that this is a zero-sum game and the bigger banks benefit as the incremental deposits flow to them.

Macro Implications
The benign end-game is that the Fed will, in all likelihood, pause on interest rates and switch to an accommodative liquidity stance. This is likely to be temporary until the banking system stabilises and the run on smaller banks is contained. We may see a peculiar cycle where the Fed continues it's battle against inflation after this short spell of liquidity easing.

A harsher outcome is that the banking crisis escalates into a weak credit cycle. This would trigger a sharp growth shock, possibly recession, which would lead to aggressive rate cuts and liquidity infusion by the Fed cutting rates. That however does not appear to be a base case scenario.

Markets Fragile
The equity markets are likely to go into a risk-off scenario for some time. This would mean reduced FPI liquidity and a vulnerability on the downside for many stocks. Two sets of stocks are likely to face the brunt – stocks with fragile fundamentals (weak balance sheets, low return ratios, etc) and ultra-expensive stocks that are trading above the historic valuation range. We will remain cautious and continue to watch the external risks.

Sectoral Impact
We see no direct impact on the Indian banks – this is largely an issue with domestic US banks and is likely to be contained within those shores. There are some worries about Indian IT companies that may have exposure to these mid-size banks: these are being dimensioned and we are watchful on the sector.

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