The Financial Select Sector SPDR (NYSEArca: XLF), the largest financial sector exchange traded fund, and rival financial services ETFs have retreated in recent days, but some market observers believe the outlook for the sector is mostly solid heading into 2018.
Rising interest rates are seen helping U.S. banks and the related ETFs. The Federal Reserve has boosted borrowing costs twice this year and bond market observers widely expect a third rate hike when the Fed meets in December.
Regional bank ETFs were banking on higher interest rates to boost their fortunes. Higher interest rates would help widen the difference between what banks charge on loans and pay on deposits, which would boost earnings for the financial sector. Regional banks are among the stocks most positively correlated to rising interest rates because higher rates improve net interest margins.
“Fitch Ratings’ sector outlook for U.S. banks in 2018 is stable, reflecting our expectation of marginally improving profitability in 2018 offset by modest asset quality weakening, driven by rising interest rates,” said Fitch Ratings in a note out Monday. “We expect the operating environment for U.S. banks to remain stable in 2018, with economic growth offering support for further rises in short-term interest rates.”
The financial services sector could be working its way into a period of long-term out-performance. The recent rally in the sector could still be in the early innings, according to some market observers.
The annual stress test has also paved the way for the biggest U.S. banks, increasing investors’ outlook for more stock buybacks and dividend payouts.
Related: Tax Reform Plan Could Have a Treat for Banks
Deregulation could also help the financial sector improve their margins. President Donald Trump’s administration has shown its eagerness in cutting back the red tape and remove some of the post-financial crisis regulations that has stifled the industry.
“Most of the U.S. banks we rate are benefiting from rising interest rates. They have been able to increase net interest margins and could benefit from further rate rises. However, if a flatter yield curve persists net interest margins will come under pressure, and it could hinder earnings growth,” according to Fitch Ratings.
Capital levels at major U.S. banks are viewed as solid. Additionally, the Trump Administration’s tax reform effort is seen as a potential catalyst for the financial services sector, but it remains to be seen if that effort will come to life.
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