Bank stocks and financial sector exchange traded funds were the biggest losers in U.S. markets as traders weighed the potential years of uncertainty in response to the passing “Brexit” referendum.
Recent weakness in the financial services sector, the second-largest sector weight in the S&P 500, may not be an invitation to embrace the group. At least not right now.
ETFs such as the Financial Select Sector SPDR (NYSEArca: XLF), iShares U.S. Financials ETF (NYSEArca: IYF) and the Vanguard Financials ETF (NYSEArca: VFH) have been under pressure following the Brexit outcome, but there are other factors at play, including the Federal Reserve’s refusal to raise interest rates to this point in 2016.
Related: Financial Sector ETFs Plunge on Brexit Contagion
Investors previously expected the Fed to increase interest rates at least twice this year, which would help bolster banks’ revenue from loans and credit cards. Futures traders now see a 22% chance the Fed will cut borrowing costs by year-end, Bloomberg reports.
[related_stories]With a steepening yield curve, or wider spread between short- and long-term Treasuries, banks could experience improved net interest margins or improved profitability as the firms borrow short and lend long.
Moreover, the financial sector received a boost from Presidential candidate Donald Trump after he proposed dismantling nearly all of Dodd-Frank, the package of financial reforms placed after the global financial crisis. However, the Fed has proved uncooperative when it comes to boosting rates and the latest FOMC minutes reveal the central bank’s concerns about the labor market, decreasing the likelihood of near-term rate hikes.
“Too early to buy the dip in bank stocks if longer-term interest rates remain this low. With the 10-year UST yield at all-time lows, we estimate ~10% median downside to bank earnings if securities exposure was immediately re-priced to market rates, which compares to the ~9% pullback in the BKX following the Brexit vote. Pro forma P/E and P/PPNR valuation multiples in this securities shock scenario are just in line with historical levels,” according to a Baird note posted by Ben Levisohn of Barron’s.
Related: Financial Sector ETFs Maintain Momentum
Financial entities like banks will benefit from expanding margins as rates climb. A rising rate environment may reflect a strengthening U.S. economy, and a healthier economy would help borrowers have an easier time repaying loans, with banks stuck with fewer non-performing assets. Moreover, rising rates means that banks will generate greater revenue from the spread between what they pay deposit savers and the prime rates they charge credit-worthy clients and other highly-rated debt.
For more information on the Brexit fallout, visit our Brexit category.
Financial Select Sector SPDR
