JM Financial explains how the US Federal Reserve’s 50 basis point interest rate cut will impact the IT sector

The recent 50 basis point cut in interest rates by the US Federal Reserve has sparked discussions about its impact on various sectors. National brokerage house JM Financial has analyzed the potential effects on the IT sector. The JM Financials report indicates that while the interest rate cut could benefit IT services, its impact will be complex and tempered by economic uncertainty.

JM Financial has analyzed S&P 500 companies (excluding financials) and observed three trends: gradual increase in interest expense, marginal reduction in debt across sectors and decline in operating expenses relative to revenue. These trends indicate that companies have optimized debt and operations to manage higher interest expense. However, the impact of interest rate cut on corporate spending is likely to be gradual and expectations of immediate increase in spending may be premature. JM Financial’s top picks in this sector include Infosys, Tech Mahindra, Wipro in large caps and Persistent Systems and KPIT in mid caps.

The U.S. Federal Reserve initiated a new round of monetary easing by cutting the federal funds rate by 50 basis points (bps), marking its first cut since March 2020. This followed a 14-month pause in monetary policy that left the federal funds rate in a range of 4.75% to 5.00%.

Impact of interest rate cuts on the IT services sector: three key implications

JM Financial identified three main implications of lower interest rates for the IT services sector: higher equity multiples due to a lower cost of equity capital, a potential pick-up in discretionary demand as the economy recovers, and lower corporate interest burdens enabling higher operating expenses (opex).

Of these, increased inventory multiples have already materialized to some extent, while the recovery in discretionary demand remains uncertain, dependent on the nature of the economic recovery. However, the most tangible impact is likely to be the reduction in interest charges, which could benefit the communications, media and entertainment (CME) and manufacturing sectors.

Companies like Tech Mahindra, with significant exposure to these sectors, are better positioned to capitalize on this shift. Meanwhile, a pick-up in spending by US banks would provide a bigger boost to companies like Infosys, TCS and Wipro.

Trends in the IT sector

As mentioned above, JM Financial has also identified three key trends that the IT sector is likely to focus on

1) The growth trajectory of interest costs for businesses across all sectors has been slower than the Fed’s interest rate hikes,

2) Many sectors have seen little debt reduction over the past four years,

3) Operating expenses as a percentage of revenues generally declined.

These trends indicate that companies are optimizing debt and operations to mitigate the impact of higher interest costs.

It further indicated that this optimisation was particularly visible in the manufacturing and CME sectors, benefiting companies such as Tech Mahindra. However, longer-dated debt may have limited the transmission of lower rates, meaning the impact of rate cuts on spending may be gradual. JM Financial cautioned against expecting an immediate increase in corporate spending as the optimisation cycle is still ongoing.

The analysis also found that while a reduction in operating expenses (opex) is visible, it is not entirely explained by the interest burden. Instead, the reduction in opex seems more related to a reversal of IT overspending following the COVID-19 surge. The IT spending recovery, JM believes, will be driven by normalization of corporate spending, rather than lower interest rates alone. The corporate spending optimization cycle, particularly in IT, is likely to moderate over time, providing additional benefits to the sector, the broker added.

Historical context

According to the broker, historically, the start of the Fed’s rate cut cycle has coincided with a slowdown in IT services exports. This trend is driven by two factors: a previous strong demand growth cycle and the onset of a recession after peak interest rates. However, the current cycle is different from previous ones, as the US economy is not facing an immediate recession and IT spending has already normalized to some extent. As such, the slowdown may be less pronounced this time around, with gradual improvements expected in the sector.

Multiple expansions included in the price

One of the more technical implications of a rate cut is a lower cost of equity, which typically results in higher price-to-earnings (PER) multiples for stocks. JM Financial noted that multiple expansions due to a rate cut may already be priced in. The report compared the NIFTY IT earnings yield with the US 10-year Treasury yield, finding that for the first time since 2007, the bond yield rose above the earnings yield for the IT index. This suggests that the market has already anticipated a decline in bond yields, limiting the immediate impact of the rate cut on IT services P/E multiples.

In summary, JM Financial believes that the Fed rate cut will have a gradual and measurable impact on the IT services sector. While lower equity costs have already led to higher equity multiples, the recovery in discretionary demand remains uncertain and dependent on broader economic conditions. Reduced interest burdens are likely to benefit sectors such as CME and manufacturing, which would benefit companies such as Tech Mahindra. A more significant boost could come from a recovery in spending by US banks, which would benefit large IT firms.

Disclaimer: The views and recommendations presented above are those of the individual analysts or brokerage firms and not Mint. We recommend that investors consult certified experts before making any investment decisions.