Stronger earnings by Citigroup Inc (C.N) show it is on the path to recovery but its broad presence in emerging markets, many of which are experiencing slowing economic growth, may temper investors' optimism.
Emerging markets have fueled two-thirds of Citigroup revenue growth for the last two years. The bank operates in about 100 countries globally, far more than most of its U.S. competitors, which means it can be hit by economic factors that shareholders know little about.
"If anything goes bump in the world, Citigroup may well have some exposure," said Fred Cannon, an analyst at Keefe, Bruyette & Woods.
The slowdown in U.S. and European economies has made developing countries as a whole look riskier. So far this year, emerging market stocks, as measured by MSCI's index .MSCIEF, have declined about 12 percent, while the U.S. benchmark Standard & Poor's 500 index .SPX has gained about 15 percent.
China said on Monday its economy grew at an annualized rate of 7.5 percent in the second quarter, the ninth quarter in the last 10 in which expansion has weakened, which could spill over to other Asian nations as well as Latin American countries that sell resources to China.
Some of these growth concerns have started to show in Citigroup's results.
Credit losses in Latin American retail banking rose 51 percent to $204 million. The bank also decided to set aside more money to cover loan losses in markets including Latin America and Asia, in part because of more troubled corporate borrowers there.
The bank's loans to the three biggest Mexican homebuilders are an example of unanticipated risk. Geo (GEOB.MX), Urbi (URBI.MX), and Homex (HOMEX.MX) snatched up large tracts of land in ex-urban areas, but the Mexican government in February said it was more interested in lending to home buyers in urban areas. Now the companies are facing cash shortfalls and lawsuits.
The builders may end up doing just fine - the government said their land will still qualify for subsidies. Citigroup said that its loans are nearly 100 percent collateralized, and that its exposure to the loans is just about $300 million. It is monitoring the situation.
Chief Executive Michael Corbat, long a proponent of emerging markets, acknowledged that "growth is being challenged" there now. The bank got more than 40 percent of its revenue for the first half from developing nations.
Analysts said Citigroup's shares reflect the rising risk that investors see in the bank's exposure to developing countries. In trading from the end of May until Citigroup reported results, the company's shares fell 2.3 percent while the broader KBW banks index .BKX rose 4.7 percent.
To be sure, investors are hardly panicking. The bank's shares rose nearly 2 percent to $51.81 on Monday after it reported a 42 percent rise in second-quarter profit as trading revenue soared and losses from bad mortgages tapered.
Even if overall annual growth in emerging markets is dipping to about 4.7 percent, Chief Financial Officer John Gerspach said Citigroup still prefers their prospects to those of the United States, where growth could be just around 2 percent this year, and Western Europe, which might shrink.
Corbat said he is not reconsidering the bank's broad strategy of focusing on these areas, a notion that current and former executives privately confirm.
Veteran banking analyst Charles Peabody said earlier this month that emerging market problems could hit Citigroup in two ways: first by national economic slowdowns, and then by currency losses to the bank as nations cut interest rates to spur their economies.
"I don't mind emerging market currency risk as long as the growth prospects are there, but growth is decelerating, which is obviously forcing the easing of monetary policy, which is causing the currencies to decline," Peabody said.
Put differently, the potential downsides to being heavily invested in emerging markets are as big as ever, while the upsides seem to be declining.
Emerging markets may be poised for greater growth than developed markets, Peabody said, "but getting from here to there is going to be very dicey."
(Reporting by David Henry; Editing by Dan Wilchins, Paritosh Bansal and Chris Gallagher)