With the Federal Reserve raising interest rates, conventional wisdom said the financial sector was poised to do well.
After all, higher interest rates can mean that banks’ net-interest margin could grow as the amount of interest paid out to depositors relative to the loans they make expands.
This idea worked in the financial sector’s favor last year when the sector outperformed the broader Standard & Poor’s 500. Now, with a growing economy, tax cuts and now a rollback in Dodd-Frank regulations put on banks following the 2008 credit crisis, analysts say macroeconomic factors continue to point in banks’ favor. Whether big banks or regional banks will benefit the most is up for debate, but market watchers say within the financial sector itself, banks will likely do better than insurance companies and asset managers.
The three biggest financial-sector ETFs follow the big banks, with the Financial Select Sector SPDR Fund (XLF) the largest with $32.7 billion in assets under management and an expense ratio of 13 basis points. Next largest is Vanguard Financials ETF (VFH), tracking the performance of the MSCI US Investable Market Financials 25/50 Index. It has an AUM of $8.5 billion and an expense ratio of 10 basis points. A third ETF that focuses on the larger banks is iShares U.S. Financials ETF (IYF), which follows the Dow Jones U.S. Financials Index. It has an expense ratio of 44 basis points and $2.2 billion in assets under management.
So far, though, the financials sector lags the broader market. Year-to-date, XLF is up 0.15 percent, VFH is up 1.1 percent and IYF is up 1.4 percent. That puts them behind the SPDR S&P 500 Trust ETF (SPY), which is up 2.4 percent year-to-date.
However, the financial sector outperformed SPY last year. XLF’s one-year performance is up 19.8 percent. VFH’s one-year performance is 19.7 percent, while IYF is up 16.9 percent on a one-year basis. Comparatively SPY’s one-year performance was up 15 percent.
Amanda Agati, co-chief investment strategist at PNC Financial Services Group, says the big banks were leading the sector, although she thinks that regional banks may start to outperform their bigger brethren. Morgan Stanley also says both big and mid-cap banks are “attractive.”
Although financials lag the broader market now, fundamental factors underpin it. For the first time since the rising interest-rate cycle began, net-interest margins for banks started to expand in the first quarter. That took longer than expected, she says, although it ultimately should translate into return-on-equity growth.
The rising rate environment can help banks, but only if it rates are rising because of growth, rather than inflation pressure. This year, Agati says, the market experienced both.
“We had tremendous earnings growth and acceleration, so that's a check mark in the category for rates rising for the right reason. But we also have seen oil prices go up and input costs in general go up. So there is this inflation move as well. We're sort of wrestling with which one's going to win out,” she says.