Unwarranted collective optimism in banking sector

Tim Scholefield, Head of Equities at Baring Asset Management comments: "Financial stocks have underperformed during the recent rally in equity markets. Since August 16th global equities have risen by 6.7%, whereas the Banks sector has risen by just 1.8%.

"So why have banks stocks lagged? The explanation is earnings, or more specifically a growing realisation that the news on bank earnings will disappoint.

"There is plenty of evidence to confirm that demand for financial products is cooling rapidly, particularly within the household sector. In the US expectations for housing demand have slumped to 20-year lows, whilst mortgage costs are rising sharply.

"Banks have benefited from a number of very strong trends in recent years, such as securitisation and M&A activity. It is clear that the use of financial innovation and leverage has diminished sharply, and hence banks will find their revenues from corporate clients also under pressure.

"Moreover profitability is being squeezed by the difficulties faced in accessing finance. Much of the recent growth in bank assets has been funded by the ‘wholesale’ market, where banks borrow from other institutions rather than from individual savers. The cost of this source of finance has risen substantially, in turn squeezing profit margins.

"Banks will be forced to mark down the value of assets such as mortgage-backed securities and collateralised debt obligations currently held on their balance sheets. The scale of write-downs will vary from bank to bank: some will have hedged their exposure, yet the risk is of a significant knock to earnings for the sector as the impact of the events of August start to become clearer.

"Whilst the Bank sector has lagged the broader market, and to some eyes may now start to look attractive, we would suggest that there is unwarranted collective optimism amongst investors in this sector and, until earnings expectations have caught up with reality, it will pay to remain cautious."