By Deepika Sharma, Astor Investment Management – Senior Managing Director & Portfolio Manager
Effective September 1, 2016, the Global Industry Classification Standard (GICS®) will undergo its first major change since its inception in 1999 when real estate will be carved out of the financial sector. The new, 11th, sector will primarily contain equity REITs.
MSCI will make the change on Aug 31, but the S&P 500 will change on September 16, which is when most sector funds will rebalance.
What does this mean for the financials ex-real estate sector?
We believe that the “new” financials will have higher volatility once real estate, which had provided diversification, is removed. REITs have a low correlation with the S&P 500 of 0.55. In addition, separating REITs, which have a dividend yield of around 3.5%, will lower the dividend yield of financials ETFs to between 1.75-2%, from 2.4%.
However, despite these headwinds from the GICS change, we still think the “new” financials sector is an attractive investment from both a macro and valuation standpoint.
In terms of pure economic fundamentals, financials are in a strong position today both relative to their own history as well as to other sectors. For example, last quarter, the financial sector was the only one with a strong upward trend in contribution to GDP.
Figure 1: Sectors ranked by Composite Valuation Indicators as of June 30, 2016. The ranking shows average of ranks for Estimated P/E 2016, Projected 5-year Earnings Growth, Price/Book and Long Term Debt/Capital. (Source: Bloomberg, Factset) Past performance is no guarantee of future results. See definitions and disclosures on the last page for additional information
Furthermore, banks and financial stocks have more than recovered from the temporary sentiment-driven sell-off led by the Brexit uncertainty as well as concerns about the Fed’s policy stance. Yet financial stocks remain undervalued relative to other sectors, based on estimated P/E 2016, price/book and long-term debt/capital.
Unless economic conditions deteriorate significantly in the next few months, we expect a stable to steeper yield curve and higher rates by early 2017.
One of the concerns voiced by market commentators is the response of interest-rate sensitive banks and financials to the next Fed hike and the beginning of a tightening cycle. However, based on Wu-Xia Shadow Fed Funds Rate calculations by the Atlanta Fed, we’re already in a mature tightening cycle with a de-facto hike of 337.5 bps since first half of 2014. The Wu-Xia shadow rate estimates the level of the Fed Funds rate equivalent to quantitative easing in a zero-bound environment.
During this time, financials have already seen the effect of monetary tightening from the end of QE and have shown resilience to the de-facto Fed Funds move. In 2015, the sector was down 33bps and is still down 1.62% on the year but has started to pick up since Q2 2016.
In our opinion, another 25bps or 50bps move is not going to significantly impair the banks’ and other financial institutions’ balance sheets.
All information contained herein is for informational purposes only. This is not a solicitation to offer investment advice or services in any state where to do so would be unlawful. Analysis and research are provided for informational purposes only, not for trading or investing purposes. All opinions expressed are as of the date of publication and subject to change. Astor and its affiliates are not liable for the accuracy, usefulness or availability of any such information or liable for any trading or investing based on such information. 308161-474