The Indian IT sector witnessed a significant rally on September 18, with major technology stocks surging up to 3% during morning trading. The uptick comes on the heels of market expectations for additional rate cuts by the US Federal Reserve in 2025.

IT Index Leads Sectoral Gains

The IT index emerged as the top-performing sector, climbing over 1% and outpacing other segments of the market. Notable gainers included:

• LTIMindtree: Leading the pack with a remarkable rise of over 3%, reaching Rs 5,609.00
• Infosys: Climbed 2% to Rs 1,555.00 per share
• Other major players: TCS, Wipro, HCL Tech, and Tech Mahindra also participated in the rally, with gains of up to 3%

Driving Factors Behind the Rally

The surge in IT stocks can be attributed to several factors:

1. US Federal Reserve Rate Cut: The Fed had recently cut interest rates by 25 basis points to the 4.00%-4.25% range, marking the first reduction this year.

2. Future Rate Cut Expectations: Markets are anticipating up to six more 25 basis point cuts by the end of next year, with expectations of two additional rate cuts in 2025.

3. Positive Impact on US Economy: Lower US rates are expected to:

   • Reduce borrowing costs
   • Support consumer spending
   • Help corporates maintain their tech budgets

4. Benefits for Indian IT Firms: Given that Indian IT companies derive significant revenue from the US market, these economic factors are seen as potentially beneficial for their business prospects.

Current Market Position

As of the morning trading session:

• The Nifty IT index was trading at 36,938.00, up 1.44%
• Despite the day's gains, the index remains down nearly 15% year-to-date

Outlook

While the day's rally provides a positive sentiment for the IT sector, investors should note that the industry has faced challenges this year, as reflected in the year-to-date performance. The market's reaction to expected US rate cuts suggests optimism about future business prospects for Indian IT firms, particularly in their crucial US market.

Investors are advised to consider both short-term market movements and long-term industry trends when making investment decisions.

In a surprising move, mutual funds have increased their allocation to the IT sector, despite significant declines in major IT stocks. This contrarian approach highlights a growing confidence among fund managers in the sector's potential for recovery and long-term growth.

Allocation Increase and Stock Performance

Mutual funds have raised their allocation to IT stocks to 7.9% in August, up from 7.8% in July. This increase comes against a backdrop of substantial declines in major IT companies:

• Tata Consultancy Services (TCS): Down 32% from peak
• HCL Technologies: Declined 27%
• Infosys: Fell 25%

Sector Ranking and Fund Flows

The IT sector now ranks third in mutual fund allocations, following:

1. Private Banks: 17.5%
2. Automobiles: 8.5%
3. IT: 7.9%

Infosys, in particular, has seen significant interest from mutual funds, receiving the largest inflow of Rs 5,000 crore. The company has also announced a substantial Rs 18,000 crore buyback, signaling confidence in its financial position and future prospects.

Attractive Dividend Yields

One factor drawing mutual funds to IT stocks is the attractive dividend yields they currently offer:

These yields provide a cushion for investors in a sector that has faced recent challenges.

Fund Managers' Perspective

Fund managers cite attractive valuations after a three-year downcycle as a primary reason for their contrarian approach. The significant stock price declines have created potential buying opportunities for those with a long-term investment horizon.

Challenges and Future Outlook

Despite the optimism from mutual funds, challenges remain for the IT sector:

• Jefferies warns that artificial intelligence (AI) may drive a 20% revenue deflation in IT services over the next five years.
• The research firm expects only 3.8% growth for the sector during this period.

These projections suggest that while there may be short-term opportunities, the long-term landscape of the IT services industry could face significant disruption.

Conclusion

The increased allocation to IT stocks by mutual funds, despite recent market performance, reflects a complex interplay of factors. While attractive valuations and dividend yields are drawing investors, the potential impact of AI on the sector's future revenue streams cannot be ignored. As the industry continues to evolve, investors and fund managers will need to carefully balance short-term opportunities with long-term technological trends shaping the IT services landscape.