Industry Outlook For Non-U.S. Banks

In general, we believe it is still a bit early to get involved with non-US bank stocks as the fundamental outlook remains weak — asset quality will continue to deteriorate as individuals and companies default on loans, and revenues should continue to fall as loan growth falters and investment banking faces a dearth of new business in the face of economic slowing.

Consumer job losses and sluggish business conditions are increasing worldwide, which will tend to dampen demand for credit, even assuming banks are capable of lending more. Moreover, these factors will also hurt asset quality and increase losses on the existing “good” loan portfolios, even apart from considerations of toxic assets. Combined with top-line pressure due to weakening economic conditions, non-US banks face a daunting outlook.

That said, we believe that banks in stable emerging economies, such as Chile, Brazil or India, may be more attractive investments — similar to what we expect for certain regional banks in the US. To be sure, banks in emerging economies will face asset quality issues; however, they are not confronted with other significant problems that many of the larger banks in Europe and the United Kingdom are, such as toxic securities, dilution from capital raising and dividend cuts/omissions. Moreover, these emerging market banks generally tend to be well capitalized, aren’t as heavily exposed to the property markets, and have significant and generally growing sources of noninterest income.

In fact, Zacks-covered banks in Latin America and Asia have outperformed both the S&P 500 year to date, as well as Zacks-covered banks in Europe and the United Kingdom, increasing 40.1% and 27.7%, respectively, versus gains of 3.3% for the S&P 500 and 10.6% for banks in Europe and the United Kingdom.

There are several caveats one should consider when investing in these banks. First, investment in non-US ADR bank stocks entails foreign currency risk. Currently, the US$ is appreciating against many foreign currencies, which tends to depress US$ share performance. On the other hand, when this turns and the US$ starts falling against other foreign currencies, this will accelerate gains in US$. More importantly, we expect stock prices to continue volatile, reflecting economic uncertainty in the coming months and headline risk.

OPPORTUNITIES

Specific banks that we like include Itau Unibanco Holding S.A. (ITUB: 17.55 0.00 0.00%) in Brazil, Banco Santander Santiago (SAN: 49.23 0.00 0.00%) in Chile and HDFC Bank Limited (HDB: 92.51 0.00 0.00%) in India.

ITUB is the largest bank in Brazil following the February 2009 merger of Uniao de Bancos Brasileiros S.A. and Banco Itau Holding Financeira S.A., with R$575 billion (US$240 billion) in assets, 4,800 branches, and a 19% share of the Brazilian loan market.

SAN is the largest private bank in Chile (total assets of Ch$21,137 billion or US$33.6 billion at year-end 2008) and is 77% owned by Banco Santander Central Hispano, the largest bank in Spain and one of the largest in Europe.

HDB is now one of the largest banks in India, with Rs183,271 crores, or US $35.1 billion, and a retail network of 1,412 branches and 3,295 ATMs in 528 cities for the fiscal year ending March 31, 2009.

There are currently three stocks in the Zacks covered non-US bank universe with a Zacks ranking of 1 (Strong Buy) — Credit Suisse Group (CS: 44.96 0.00 0.00%), HDFC Bank Limited and ICICI Bank Limited (IBN: 29.73 0.00 0.00%) — and three stocks that have a Zacks rank of 2 (Buy) — Itau Unibanco Holding S.A., Banco Bradesco S.A. (BBD: 15.42 0.00 0.00%) and Deutsche Bank AG (DB: 65.91 0.00 0.00%).

WEAKNESSES

We would avoid the larger banks in the Great Britain and Ireland, particularly those that that have participated in government recapitalization programs, such as The Royal Bank of Scotland Bank plc (RBS: 14.29 0.00 0.00%) and Lloyds Banking Group plc (LYG: 5.50 0.00 0.00%) in Britain and Allied Irish Banks (AIB: 4.50 0.00 0.00%) and The Governor and Company of the Bank of Ireland (IRE: 9.58 0.00 0.00%). In return for the government capital and asset quality protection, these banks must submit to other government intervention, including limits on dividend payouts and nomination of board members. This will limit their financial flexibility for awhile and raise issues of complete nationalization, which could continue to hurt share price performance.

Current Sells include Banco Bilbao Vizcaya Argentaria, S.A. (BBV: 15.34 0.00 0.00%) and Banco Santander Central Hispano, S.A. (STD: 13.86 0.00 0.00%), both headquartered in Spain. In Spain, the recent collapse in housing and construction, which propelled economic growth for the last decade, is expected to stall for the next few years. Moreover, the International Monetary Fund (IMF) believes that Spain will be harder-hit by the global economic downturn than other European countries. Indeed, Spain’s unemployment rate was 17.4% at the end of March, more than double the level a year ago.

There is currently one stock in the Zacks covered non-US bank universe with a Zacks ranking of 5 (Strong Sell) — Banco Bilbao Vizcaya Argentaria, S.A. — and one stock that has a Zacks rank of 4 (Sell)– Mitsubishi UFJ Financial Group, Inc. (MTU: 5.71 0.00 0.00%).