As was widely reported, financial services stocks and the related exchange traded funds were epic disappointments in 2018. Last year, the Financial Select Sector SPDR (NYSEArca: XLF), the largest ETF tracking the sector, slumped 13% even as the Federal Reserve boosted interest rates four times.
The new year is still in its early stages, but the sector is rebounding. As of Thursday, Jan. 24th, XLF was up 8.30% year-to-date. Some market observers believe that rally is credible and could prove durable.
“Unfortunately, short-term interest rates increased more than long-term interest rates last year, flattening the yield curve and curbing financials’ profitability,” said State Street in a recent note. “In addition, attractive relative valuations combined with a less burdensome regulatory environment at the start of last year also led investors to aggressively overweight the financial sector.”
When the sector struggled against the backdrop of short-term rates rising faster than long-term rates, investors grew anxious and rapidly departed funds like XLF.
“When things didn’t pan out as they planned, investors lost patience with their financial sector positions, withdrawing nearly $9 billion from financial sector exchange traded funds (ETFs)—the greatest outflow of the 11 economic sectors,” said State Street.
Better Things In 2019
Earnings seasons has been solid for the financial services sector and the flatter yield curve could provide the foundation for more upside for bank stocks.
“Expectations for a flatter yield curve in 2019 will continue to weigh heavily on investor sentiment for financials,” according to State Street. “However, the Fed has signaled a slowing of interest rate increases in 2019. In fact, 2-year Treasury rates have already fallen from a high of 2.97% in November to 2.54% more recently. The yield curve may not flatten as much as investors are expecting. Maybe it will even steepen some this year and unexpectedly boost financials’ profitability.”
Related: 10 Bank ETFs Investors Can Bank On
Additionally, the sector’s valuations are significantly depressed following last year’s slide. While valuations for financials are low, earnings growth remains solid.
“Trading at an eye-popping 55% discount relative to the broader market based on price-to-earnings multiples, it potentially offers compelling value to investors willing to accept the risk of investing in the sector,” according to State Street. “According to FactSet, fourth quarter earnings per share (EPS) growth for financials will be more than 10%, roughly in line with the market EPS growth rate.”
For more information on the financials sector, visit our financial category.