Emkay Global turns cautious on PSU banks as treasury gains fade, RoE comes under pressure and credit costs may normalise
Public sector banks (PSBs), which have been among the strongest performers in the Indian equity market since the September 2024 market peak, could face a more challenging environment in FY27. Seshadri Sen, Head of Research and Strategist at Emkay Global Financial Services, believes the sector has limited room for further re-rating after its sharp run-up and investors should now focus more closely on earnings quality and sustainable return ratios.
Sen’s cautious stance comes even as the broader earnings environment is showing signs of improvement. He expects stock-specific opportunities to become increasingly important as the market moves into a phase where earnings growth, rather than valuation expansion, could determine returns.
Q1 earnings point to improving corporate profitability
The June quarter results offered encouraging signs for Indian companies. According to Sen, topline growth recovered to 18.5 per cent, while EBITDA margins remained resilient at 18.2 per cent. Profit after tax increased 19.8 per cent, indicating that the earnings recovery is becoming broader.
Materials emerged as the strongest-performing sector, with PAT growth of 49.9 per cent. Telecom recorded 30.9 per cent growth, while financials delivered 22.7 per cent growth.
Sen believes the worst of the earnings slowdown may now be behind India Inc. Improving demand conditions and operating leverage could provide further support in the coming quarters.
Why PSU banks could struggle in FY27
Despite the strong rally in PSU bank stocks, Sen believes FY27 could be considerably more challenging.
A major headwind is the expected reduction in treasury profits. These gains contributed between 6 per cent and 21 per cent of profit before tax for PSU banks in FY26. As this benefit fades, earnings growth could slow sharply, with EPS growth potentially falling into the low single digits.
Return on equity could also weaken. PSU banks have already benefited considerably from improved asset quality, lower credit costs and balance-sheet repair. With fewer incremental RoA levers available, sustaining the same level of profitability could become difficult.
Credit costs remain a key risk
Another concern is the possibility of credit costs normalising. The improvement in asset quality has been an important driver of PSU bank profitability in recent years.
If credit costs begin moving higher from favourable levels, the impact could reduce earnings momentum. This creates a challenging setup for banks that have already witnessed significant valuation expansion.
For investors, this means the sector's earlier re-rating may not necessarily continue at the same pace.
Mid- and small-caps retain an advantage
Sen expects mid- and small-cap stocks to remain relatively better positioned than large-caps.
The Nifty 100 has significant exposure to relatively slower-growing sectors such as banks, IT, FMCG and energy. In comparison, the broader SMID universe has greater exposure to companies operating in higher-growth segments.
This difference in earnings momentum could allow selected mid- and small-cap stocks to continue outperforming large-cap benchmarks, although stock selection and valuation discipline remain important.
Which sectors could outperform?
Ahead of the September quarter, Sen remains positive on discretionary consumption, real estate and industrials.
Autos and discretionary businesses could benefit from improving consumer demand. Capital goods companies are expected to gain from continued government and private-sector capital expenditure.
Healthcare remains attractive because of its relatively stable structural growth profile, while real estate could benefit from the ongoing housing upcycle.
Domestic growth themes remain preferred
In the absence of a large number of pure-play artificial intelligence companies in India, Sen prefers businesses benefiting from India's domestic growth cycle.
Autos, discretionary consumption, capital goods, healthcare and real estate are among the preferred sectors. Factors such as GST rationalisation, lower interest rates and expectations surrounding the 8th Pay Commission could provide additional support to consumption-oriented businesses.
Can the Nifty recover?
Sen believes the market's recent weakness could reverse if external conditions remain supportive. The earnings recovery, easing FPI selling and more reasonable valuations provide a better foundation for the market.
However, three factors will remain crucial: the durability of earnings growth, foreign investor flows and the global macroeconomic environment.
Global interest rates, crude oil prices and geopolitical developments could continue to create volatility. A fresh external shock could delay the anticipated recovery.
What it means for investors
The outlook suggests that investors may need to move away from simply chasing sectors that have already delivered strong returns. In PSU banks, the combination of fading treasury gains, potentially higher credit costs and limited improvement in return ratios could restrict further upside.
On the other hand, companies with stronger earnings visibility and exposure to domestic growth themes could offer better opportunities.
Market Outlook
The Indian market appears to be entering a phase where earnings quality could matter more than broad-based re-rating. PSU banks have delivered a powerful rally, but FY27 could bring tougher comparisons and fewer easy profitability gains.
Investors may therefore prefer a selective approach, focusing on businesses with sustainable earnings growth, healthy balance sheets and clear demand visibility. Autos, capital goods, discretionary consumption, healthcare and real estate remain key sectors to watch, while PSU banks may require greater valuation and earnings scrutiny after their strong run.
For investors, the key message is clear: the next leg of market returns may come less from re-rating and more from companies that can consistently deliver earnings growth.