Updated to clarify that Morgan Stanley CFO said the fixed income environment was more challenging than the fourth quarter of 2010 and not 2008. We regret the error.

NEW YORK (

TheStreet

) -- The outlook for investment banking -- and the capital markets divisions of banks -- is looking pretty dismal for the third quarter. Virtually every line of business is seeing the impact of continued uncertainty in Europe and significantly weaker global economic forecasts.

JPMorgan Chase

(JPM) - Get Report

warned recently that its third quarter markets revenue will likely be lower by 30% on a sequential basis and that investment banking revenue could fall by as much as 50%, setting off a raft of earnings downgrades across large banks, including

Bank of America

(BAC) - Get Report

and

Citigroup

(C) - Get Report

.'

>>6 Banks Set for Third Quarter Earnings Implosion

But it's pure-play investment banking names like

Goldman Sachs

(GS) - Get Report

and

Morgan Stanley

(MS) - Get Report

that have seen the steepest cuts to estimates.

Fixed income trading, which dinged the revenues of Goldman Sachs last quarter, would likely continue to be the sore spot across the industry.

Morgan Stanley CFO Ruth Porat recently indicated that the fixed income environment was even more challenging than the last quarter of 2010

, which was decidedly weak for all investment banks.

Persisting fears about the European debt contagion has led to a widening of credit spreads and higher levels of illiquidity in the European markets. In the U.S., credit and commodities trading revenue has remained soft.

However, other segments including equity trading and high-margin investment banking fees offer little positive offsets to fixed income trading. While volumes in equities have been fairly robust, analysts expect that the volume mostly came from mostly low-margin electronic trading business.

Merger activity slowed significantly in the third quarter on the back of a weakening global economy. Higher volatility in the equity and debt markets also caused companies to pause their capital raising plans.

Barclays Capital analysts estimate that investment banking revenue likely declined by 40% sequentially in the third quarter with bulge bracket firms seeing declines between 35% and 60%.

Against a weakening revenue outlook, the focus will be on attempts to cut compensation costs, the biggest lever that drivers profitability for investment banks. Most of the adjustments to compensation usually happen in the fourth quarter, however.

Investment banks have been at the forefront of the bank layoffs, as they have more operational flexibility to reduce headcount compared to commercial banks.

>>12 Banks Slashing Jobs

Still, it appears that the markets have been ahead of the analyst community in predicting the weak operating environment. Shares of Goldman Sachs and Morgan Stanley are down 30% and 42% respectively in the last three months.

Trading at well below book value, the stocks' current valuations appear to be capturing not only a weak third quarter but also a grim operating environment for several quarters ahead.

That may well be the case. Bernstein analyst Brad Hintz expects fixed income revenue, the biggest contributor of trading revenues at JPMorgan and Goldman Sachs, to rise only 5.3% in 2012 over the Street's 2010 run rate and a 9.6% increase in 2013 above the 2010 level.

According to Hintz, fixed income trading normally performs well during economic downturns as investors first shift into government securities and then later into credit sector as the economy hits bottom.

However, the Fed's efforts to flatten the curve set the stage for a very "unusual fixed income environment in which demand for spread products is constrained and a rally in credit is delayed."

Analysts at Citigroup and UBS also expect a more prolonged cycle of weakness for investment banks.

"Forecasting trading revenues one quarter out is challenging, let alone trying to estimate 2013. That said it's hard to assume as a base case that global trading pool revenues increase meaningfully vs 2011 levels with a weak economic outlook plus continued uncertainties regarding impact of regulation and higher capital requirements," Citi analyst Keith Horowitz wrote in a note.

UBS analyst William Tanona also expects current headwinds to hinder universal banks and brokers for a number of quarters. "A longer term view than we originally anticipated is required. However, we believe valuations have already contracted to a level that reflects the challenging near-term operating environment."

Here is what to expect from the biggest players -- Goldman Sachs and Morgan Stanley -- when they report next month.

Goldman Sachs

Second Quarter Performance:

Goldman Sachs disappointed analyst expectations during the second quarter both on the topline and bottomline, as its trading division took a big hit.

The investment bank earned net income of $1.09 billion or $1.85 per share in the second quarter, compared to $613 million or 78 cents per share in the year-ago quarter. Excluding one-time items, Goldman earned $2.75 per share in the year-ago quarter.

Revenues came in at $7.28 billion, down 18% from $8.84 billion reported in the corresponding previous quarter.

Revenue from fixed income trading, which accounts for more than two-thirds of trading business, came in at $1.60 billion, plunging 63% from the first quarter and down 53% from the year-ago quarter. It was one of the few quarters in which Goldman has substantially underperformed in fixed income trading since its IPO.

Outlook:

The consensus expects Goldman Sachs to report a third quarter earnings per share of $1.34, down 55% from the year-ago period and 27% from the previous quarter.

Barclays Capital analyst Roger Freeman has a more dire forecast. He expects the investment bank to post a loss of 35 cents per share, the second loss in its history after the fourth quarter of 2008.

The investment bank's biggest losses are forecast to come from its principal investing and lending business, affected by broad market declines. Trading and investment banking revenue are also forecast to be weak. Weak equity markets are Goldman Sachs "Achilles Heel" Barclays noted in its report.

On the larger issue of whether Goldman would eventually be able to deliver return on equity above the single digits being reported now, Morgan Stanley's Betsy Grasek, says she expects Goldman's ROEs to return to 12% "whether or not the risk trade comes back."

She expects that if the difficult operating environment persists, Goldman will eventually begin slashing headcount and investment spends. Right now, Goldman is managing its expenses through compensation rather than payrolls.

Goldman said last quarter that it could

layoff as many as 1,000 employees as it seeks to cut $1.2 billion in compensation and non-compensation expenses this year.

Morgan Stanley

Second Quarter Performance:

Morgan Stanley reported a

narrower-than-expected net loss of $558 million or 38 cents a share during the second quarter. The results included a $1.7 billion charge related to the conversion of preferred stake held by Mitsubishi UFJ Financial into common equity.

Revenue for the quarter was $9.3 billion, topping expectations. Fixed income trading revenues in the second quarter not only showed the much-anticipated sign of improvement, but delivered a sound thrashing to rival Goldman Sachs.

Outlook:

Consensus expects Morgan Stanley to report an EPS of 38 cents during the third quarter. That compares to an income from continuing operations of 7 cents a share in the year-ago quarter.

Analysts will be watching out for its performance in the fixed income trading business. The investment bank is targeting a 2 percentage point improvement in its market share in the fixed income business. Margin improvements in the global wealth management business and progress in cost cuts will be seen as catalysts for the stock as well.

Bernstein rates Morgan Stanley an outperform. "Bernstein believes that the new Morgan Stanley will be less reliant on trading and have a lower-risk business model, will control the leading market share position in retail brokerage, and will maintain its top ranking in M&A advisory and equity capital markets," analyst Brad Hintz writes in his investment thesis. "As such, the "new" Morgan Stanleyshould be able to produce lower-volatility revenues, be less capital intensive, generate a higher-valueearnings mix and operate with lower VaR(value at risk) to tangible equity than the "old" Morgan Stanley of 2006-2007."

RELATED STORIES:

>>Morgan Stanley Cuts Risk as Credit Spreads Blow Out

>>JPMorgan Chase Faces Tough Third Quarter

>> 6 Banks Set for Third Quarter Earnings Implosion

--Written by Shanthi Bharatwaj in New York

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