Financials seen outperforming industrials

NEW YORK (Reuters) - Debt of brokerages and banks is likely to outperform industrial credits in the coming months as the credit crisis spreads from the financial sector to the rest of the economy, hitting cyclical companies the most.

Although disappointing quarterly results and additional write-downs due to the deteriorating mortgages may still hit financials, further downside is limited because the sector has already taken a heavy beating.

The credit profile of companies in basic industries, media and retail, however, is expected to deteriorate as their earnings decline as the economy weakens.

Investors got their first preview of declining earnings last Friday when General Electric Co (GE.N), which has interests in just about major sector of the global economy, reported lower-than-expected first-quarter results.

"Financial credits are normally fairly resistant to the economic cycle compared with industrials," Jeffrey Rosenberg, head of credit strategy research at Banc of America Securities, said in a report.

"As financial risk reduces further and clearly is spreading to the economy, we expect strong outperformance in financial credits relative to industrials," he added.

Banc of America Securities changed its recommendation for brokers to overweight from marketweight, and said investors should be underweight media, retail, technology, transportation and chemical companies.

Since the start of the year, first-quarter earnings estimates for Standard & Poor's 500 companies have fallen to negative 13.5 percent from positive 5.7 percent, according to a report by JPMorgan analysts.

But in contrast to the fourth quarter, when an earnings decline was mostly attributed to financials, first-quarter estimates show a broad-based slowdown across most industrial sectors except energy.

"As the effects of a recession begin to overshadow the credit crisis, we would expect to see relative values for financial institutions and industrials return to a more normal pattern," the JPMorgan report said.

Financials are now trading 28 basis points wide to industrials, while typically financial spreads should be tighter than industrial spreads, JPMorgan said.

The spread between U.S. financial corporate bond yields and Treasuries has almost tripled since the start of the credit crisis in August to 320 basis points, while the industrial sector has seen less widening to 262 basis points, according to Merrill Lynch indexes.

"We continue to recommend large well-diversified financials and high quality non-cyclical industrials," Lehman Brothers said in a report.

But investors should buy protection on debt of industrial companies, whose results are highly correlated with the economic cycle, Lehman Brothers said in a report.

The Federal Reserve's decision to open the discount window to brokers also bodes well for this sector, even as some banks continue to report disappointing results and still face write-downs.

For example, Merrill Lynch & Co. MER.N is expected to announce $6 billion to $8 billion of asset write-downs in its first-quarter results on Thursday, according to The Wall Street Journal.

Wachovia Corp WB.N, the fourth-largest U.S. bank, posted a surprise loss on Monday. Washington Mutual (WM.N) also reported a huge loss after increasing provisions for losses as more mortgage borrowers fall behind on payments.

"While deleveraging and writedowns remain, those issues are likely more absorbed by the equity than credit," Rosenberg said.

(Editing by Leslie Adler)