With the level of Fed paranoia steadily rising on Wall Street, investors holding financial stocks are hoping Thursday's earnings report from Citigroup ( C) will remind bears how well a bank can perform with or without a macroeconomic tailwind. But Sandy Weill's behemoth is so big and its portfolio of businesses so diverse, it's possible a strong quarter at Citi won't be the panacea the broader sector has been craving. Lately, bank stocks have been reeling as investors fear a reckoning is nearing after three years of easy monetary policy. Those fears were fanned again Wednesday with news from the Labor Department that consumer prices rose more than expected in March. Not even a spate of good earnings reports from the likes of Bank of America ( BAC), State Street ( STT), SunTrust ( STI) and Commerce Bank ( CBH) has been able to stop the selling. The Philadelphia KBW Bank Index is down 3% since April 2, when the government reported a better-than-expected March jobs report. While
some bank shares still represent value , the larger sector is in trouble. Can Citigroup give the sector a jolt when it reports first-quarter earnings before the bell Thursday? From a numbers perspective, the world's largest financial services firm probably won't disappoint. Bank analysts, according to Thomson First Call, expect Citigroup to earn 94 cents a share in the quarter, a 19% increase over the year-ago period. But many on Wall Street say they wouldn't be surprised if Citigroup posts sharply higher quarterly profits than the $4.8 billion most are expecting. A year ago, the bank earned $4.1 billion. Analysts at Fox-Pitt Kelton, which specializes in financial services firms, say Citigroup is one of a few banks that could post an upside earnings surprise. Overall, Fox-Pitt Kelton is bearish on bank stocks, expecting one-third of those it covers to miss earnings expectations because of a combination of weak commercial loan growth, slow fee growth and falling mortgage income.
But Citigroup's diversification should enable it to avoid the potholes that may trip up smaller banks. Citigroup's consumer lending operation, credit card division and investment bank all are expected to post big year-over-year income gains. Like Merrill Lynch ( MER), which earlier this week reported a 95% rise in first-quarter earnings, look for Citigroup to benefit from a surge into stock underwriting and stock trading. "I'm really hard pressed to find a business at Citigroup that we don't think is among one of the leaders," says Peter Nerby, a senior credit analyst with Moody's Investor Service. "I think the operations of the company are firing on all cylinders." Certainly, there's no denying that Citigroup is one of the country's top cash generators. In 2003 it cranked out $17.85 billion in profits, a 17% increase over the prior year. Only Exxon Mobil ( XOM), with $21.5 billion in net income, was more profitable in 2003 than Citigroup. Among banks, Citigroup's nearest competitor was Bank of America, with $10.8 million in profits. Citigroup's earnings prowess is one reason few are taking seriously the opposition several state pension funds are raising about Sandy Weill's re-election to the bank's board. Whatever ethical issues may be raised by Weill's continuing role on the Citigroup board, the bank's chairman and former chief executive is credited with building a powerhouse that others are still trying to emulate. "My view has been that if you look at the Bank One/J.P. Morgan Chase merger, part of that is a validation of the Citigroup model," says Nerby. The problem is that even a better-than-expected earnings report from Citigroup may not be enough to lift the banking sector, especially with many on Wall Street thinking the party is over for financial stocks. That's because most believe the Fed will move to raise rates sooner rather than later.
Higher interest rates tend to be bad for financial stocks, because rising rates makes some of banks' investments in mortgage-backed securities less valuable. Higher rates also discourage corporate bond underwriting and make it more expensive for consumers to take out mortgages. But a slight rise in rates would be a welcome relief to most banks, which have seen their net interest margins squeezed by historically low interest rates. Low rates have reduced the profitability of bank lending operations, because banks have little room to arbitrage the difference between their own borrowing costs and the interest rates they can charge borrowers. The real fear is that the Fed will impose stiffly higher rates next year, especially if oil and gas prices keep rising, inflation surges and the budget deficit spirals out of control. In that case, rate hikes could do serious damage to the economic recovery and send the consumer -- the one constant in everyone's economic revival scenario -- into hiding. Fear of the Fed has even got one mutual fund manager wishing he weren't limited by his fund's prospectus to investing only in financial services stocks. "I think the run is over for financial services sector," says Michael Stead, a Wells Capital Management portfolio manager who invests mainly in financial stocks. "There is a perception that an increase in interest rates is knocking banks down. It's not yet a reality, but it will be." How scared is Stead that a rate increase is looming around the corner? The portfolio manager says roughly 10% of his holdings are in cash, the maximum allowed under his fund's rules. If Stead's attitude is typical of other fund managers and investors, it's hard to see how Citigroup or any other bank stock can move much higher over the next few weeks and months.