There is still room for a run-up in U.S. stocks but perhaps not for the banking sector, where the prospect of asset shrinkage may overshadow any optimism over early signs of an economic recovery, says Barclays Capital.

The investment banking and trading division of the British bank Barclays PLC issued its global markets outlook to clients on Thursday.

On the whole, the firm's strategists expect that the much-talked-about "green shoots" seen by some economists will soon blossom into something sturdier. But the benefit to earnings probably will be felt first in sectors such as technology, which entered the recession with little debt and extraordinarily lean inventories. Banks, on the other hand, after a first-quarter windfall driven by mortgage refinancing activity, may not get another big pop in profits until the second half of 2010, said Barry Knapp, the head of U.S. equity portfolio strategy at Barclays Capital.

"The real key issue there is: Will you have negative asset growth?" Knapp said at a press gathering in New York at the former Lehman Brothers headquarters. Barclays took over the building last September when it bought the bankrupt firm's investment banking and trading businesses.

In addition to an overall drop in demand for credit, banks will have to grapple with accrued loan losses in lending categories such as commercial real estate, where the effects of the financial crisis continue to reverberate, he said.

These headwinds will be strongest for small and regional institutions with big loan books, Knapp said, but the money-center banks will continue to benefit from their investment banking operations and improved valuations of their available-for-sale securities.

So for now, he is recommending a neutral portfolio weighting for bank stocks, reserving his most positive forecasts for technology, telecommunications and discretionary consumer stocks, and he is most bearish about utilities, consumer staples, materials and energy stocks.

Barclays' strategists remain optimistic about banks' issuance of corporate bonds, arguing that economic improvements and a reduced supply of debt will lead to tighter spreads.

"We've been saying all along that if you want to play for a recovery in the banking sector," Knapp said, "you ought to be in the credit part of the capital structure."

Banks themselves, meanwhile, would do well to invest in government debt with maturities of five to seven years so long as the Federal Reserve remains determined to hold down short-term rates, said Ajay Rajadhyaksha, the head of U.S. fixed-income and securitized products strategy at Barclays.

Bank appetite for government debt will be an important factor in helping the market balance an expected increase in Treasury issuance, he added. Banks currently have less than 1% of their assets tied up in Treasuries, a figure that could rise to somewhere between 3% and 5% based on historical behavior in the aftermath of recessions, Rajadhyaksha said. He expects interest rates on 10-year notes to drift upward, to an estimated 4.2% at year's end. The Fed funds rate, meanwhile, will stay at zero through at least mid-2011, Barclays projects.

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