Uphill task for banking to grow earnings

The Goodbody Sharetrack portfolio contains a range of banking businesses, which demonstrates the diversity of activity and risk in the sector.

Included are regional retail banks such as AIB, Bank of Ireland, Barclays and Lloyds TSB, the wholesale banks JP Morgan Chase and Deutsche and supra-regionals such as Citigroup and HSBC.

Anglo Irish Bank, in contrast, is more akin to a niche player with significant exposure to the fast growing domestic economy.

The relative future performance of these stocks will depend on the mix of businesses and activities in each and how these are impacted by external events and economic conditions. Investors should also look for returns commensurate with the relative risk profile of each type of bank. In general, professional investors regard a falling interest rate environment as positive for bank stocks. Margins improve as funding costs fall ahead of loan yields, credit quality is underpinned by lower servicing costs and treasury earnings benefit from rising bond valuations.

Besides the impact of interest rate trends, other specific factors include stock market valuations and capital markets activity. Stock market valuations impact on fee generation in asset management and bancassurance activities, while the ability of investment banks to generate transaction fees depends on the level of capital market fund raising and other corporate transactions.

Notwithstanding the above, the banking industry will struggle to grow earnings in the absence of a positive economic environment. Loan growth requires the confidence of borrowers to invest, while the purchase of additional financial products is only possible where surplus income is available. In the latter respect the current market environment is highly uncertain, particularly with regard to the eventual impact of the US slowdown.

Other concerns impacting the bank sector include the extent of exposure to high yield debt, particularly telecom-related issues. In the US, forecast earnings downgrades have been driven by falling credit quality while in Europe, where credit quality is so far holding up, the issue of most concern is the performance of asset management related businesses.

In this investing environment, regional retail banks have performed relatively well in recognition of their defensive qualities and relatively high earnings visibility. With ongoing economic uncertainty, a low risk approach would be to continue with this focus and retail banks engaged in active restructuring and cost cutting programmes are of added interest.

Any signs of increased confidence in the performance of growth sectors such as technology, however, could result in investment outflows from these defensive, "safehaven", stocks. The correct anticipation of any such change of sentiment is probably the most difficult call to be made in the current market environment.

Please note that Goodbody Stockbrokers acts as broker to AIB.

Oliver O'Shea is a senior equity analyst at Goodbody Stockbrokers