The Financial Select Sector SPDR (NYSEArca: XLF), the largest financial sector-related exchange traded fund, rose about 1.6% in July, a solid performance when considering some analysts were not enthusiastic about second-quarter earnings reports from big banks. Still, the financial services sector appears to be on the mend, but it may take a while for investors to appreciate the sector’s potential.
Some strategists also argue that the financial sector may be a good area to look at this time around, given the potential for growth in a rising rate environment, along with potential tax and regulatory changes under the Donald Trump administration. After failing on the healthcare front, Congressional Republicans are likely to push forward with tax reform, looking to make that the centerpiece of their 2017 legislative accomplishments.
“Second-quarter results for U.S. banks underscored existing trends with earnings and loan growth broadly positive but still muted,” said Fitch Ratings. “Benign credit costs, slightly improved net interest margins, lower expenses and modest deposit betas were all positive factors for earnings in the quarter, although overall return metrics remained low.”
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Interest rate concerns are evident following recent commentary from some big-name bank executives. Additionally, analysts have been reining in second-quarter earnings estimates for large banks, based in large part on declining net interest margins. XLF and other financial services ETFs have been lagging the broader market this year, but XLF is higher by 7.1%.
“However, 2Q17 results had notable challenges, some of which could act as headwinds in the future. Yield curve flattening presented a challenge to more robust net interest margin growth for some banks and could affect future earnings growth. Continued Fed rate hikes could also pressure low retail deposit betas that have been reported thus far. Notably, many of the earnings calls featured discussion about how wholesale depositors would behave in the future with further monetary tightening, which may lead to further deposit outflows,” according to Fitch.
Although the Fed has raised interest rates twice this year with another rate hike likely coming before the end of 2017, there are concerns about the central bank’s dovish tone and its impact on ETFs such as XLF. It is expected the Fed will boost borrowing costs one more time before the end of this year and that as many as three rate hikes could be on tap for 2018.
For more information on the financial sector, visit our financial category.