Lackluster earnings expected from US investment banks

US investment bank earnings were likely lackluster in the fourth quarter as government debt jitters globally kept bond trading clients on the sidelines.

Morgan Stanley is trying to build up its retail brokerage and asset management businesses, but it and rival Goldman Sachs still rely heavily on fixed income trading to generate revenue. For the first three quarters of 2010, about 25% of Morgan Stanley's revenue came from fixed income trading, while for Goldman it was more than half. In the years before the financial crisis, an even higher proportion of the banks' earnings came from trading bonds, derivatives, commodities and foreign exchange -- which is why slow fixed income markets hurt so much. Since Deember 17, at least 14 brokerages have cut earnings estimates on Goldman, and a roughly similar number have done the same for Morgan Stanley, Thomson Reuters data show. "It's hard to do business when the entire bond market is consumed by the Federal Reserve buying everything that's issued," said Thomas Russo, a partner at investment manager Gardner Russo & Gardner. He maintains exposure to Goldman through his stake in key Goldman investor Berkshire Hathaway Inc. But even with this weakness, some analysts believe shares of Goldman Sachs Group Inc and Morgan Stanley have room to rise. Both investment banks will likely need a recovery in merger advisory and stock underwriting volume this year to make up for weak revenue from bond trading, analysts said. "I'm optimistic that we're in the second leg of the cycle, where fixed income passes the baton to equities and mergers," said Charlie Peabody, a veteran bank analyst at independent research firm Portales Partners. The improving cycle could lift valuations for both banks, Peabody said. Goldman Sachs shares are trading at about 1.35 times their book value, or their net accounting value, while Morgan Stanley shares trade at about 0.9 times book. Those multiple could rise to somewhere closer to 1.5 to 1.7 in the next 12 months, he said. Not all analysts consider Goldman such a good deal, however. JPMorgan Securities downgraded the firm on January 12, saying it has the most to lose from the "Volcker rule," which bars banks from making market bets with their own capital. Goldman Sachs, due to report fourth-quarter results January 19, is expected to post earnings of about USD 3.85 a share, down more than 50% from the same quarter in 2009, according to Thomson Reuters I/B/E/S. Morgan Stanley is due on January 20 and is expected to report 36 cents a share, above the 29 cents it earned a year earlier but well below its earnings in the 2010 first and second quarters. The analysts with the best track records expect Goldman Sachs to surprise slightly to the downside of the average Wall Street forecast, according to Thomson Reuters StarMine. Morgan Stanley is expected to post a strong upside earnings surprise. Fervid mergers Investors, panicked over continued weakening in European sovereign debt and confused over the impact of the US Federal Reserve's "QE2" bond-buying program, probably had little appetite for trading during the fourth quarter, analysts said. European analysts at JPMorgan Cazenove expect fixed income revenue to decline 10% from the third quarter for Goldman and 16% for Morgan Stanley. Investors say the decline is understandable and perhaps even predictable. "The bond market remains without a substantial amount of volatility," Russo said, which will have depressed results in the quarter. Still, there could be bright spots for the investment banks. Merger advisory business was likely strong as weak growth prospects spurred many companies to buy growth through acquisitions. In terms of the dollar size of deals, announced transactions rose by nearly 20% in 2010. Rising merger activity seems to have already helped Jefferies, a mid-sized investment bank that reported earnings in December for the quarter ended November 30. Jefferies posted quarterly revenue of USD 156.7 million, up 76% from the last quarter of its prior fiscal year, which ended December 31, 2009. Goldman's report will be its first chance to show off its new internal standards for disclosure, part of a 39 point plan released January 11 in response to criticism of its openness.