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Banks - Mired in recession
Action: With the Portuguese economy mired in recession, we are bearish on near-term asset quality and earnings growth. We initiate coverage of Portugese banks with an Underweight stance. Our stock ratings are Reduce BCP, Reduce BPI and Sell BES.

Analyst Mark MacRae

■ Portugal is in a recession. With private consumption falling, unemployment
soaring, the government locked into tightening fiscal policy and the strength of
the currency, there is little room for optimism. Yet the consensus is still looking
for a bounce back in the economy in 2004. Our economists disagree. While
there may be some recovery in exports, high unemployment will keep domestic
demand stagnant.

Asset quality: Tip of the iceberg
■ Given the weak economy, a rise in the level of overdue loan ratios is inevitable.
Yet the situation is even worse than it appears because the Portuguese
reporting standards for overdue loans are among the least stringent and least
transparent in Europe, understating economic exposure to non-paying clients,
creating a 'tip of the iceberg' effect.

Market exposure: Twin deficits
■ Market exposure is relatively high in the Portuguese banking sector and
declining equity prices have left the banks with substantial unrealised capital
losses on proprietary investments and deferred costs related to defined benefit
pension obligations. BCP has suffered the largest twin deficit, equating to an
imposing 39% of reported equity, while BPI and BES trail at 31% and 21%,
respectively.

Underweight Portuguese banks
■ Our earnings estimates for the sector are below consensus for 2004, given the
uncertainty about when the economy will find a bottom and the lack of
transparency in Portuguese accounting for asset quality. Current valuations fail
to offer sufficient rewards for the risk. We thus initiate coverage of the banking
sector with an Underweight stance and the following stock recommendations:
Reduce BCP, Reduce BPI and Sell BES.