What Negative Rates Are Doing to Financial Services ETFs

It is no secret that low and even negative interest rates throughout major developed markets are pinching financial services stocks and exchange traded funds and the punishment extends beyond US-focused ETFs.

Negative interest rate policies (NIRP) should lower the cost of capital with the theoretical result being companies wanting to spend more, which should prompt banks to boost lending. However, financial services ETFs are not benefiting.

Obviously, the U.S. does not have negative interest rates, but the Financial Select Sector SPDR XLF and rival diversified financial services ETFs are among this year's worst-performing sector funds. XLF, the largest ETF tracking the S&P 500's second-largest sector weight, is off 2.1 percent. XLF has rallied off its February lows, but the ETF's most recent upside is likely attributable to expectations that the Federal Reserve will raise interest rates next month, indicating XLF is back where it often is: Waiting on Fed support. 

“In this environment, low overall interest rates combined with weak levels of net income margin have made it challenging for banks to grow earnings. With the majority of companies having reported for Q1, 28% of US financials in the S&P 500 Index had missed earning expectations but 49% had missed on revenue,” according to State Street. “This compares to real estate companies, where 59% of reported REITS had positive earnings surprises and 65% were above sales expectations. Real estate companies were able to benefit from lower financing costs and improved operating leverage.” 

Real estate investment trusts (REITs) and the relevant ETFs are benefiting from low rates. For example, the $3.45 billion SPDR Dow Jones REIT ETF RWR, which yields 3.76 percent, is up 2.1 percent year-to-date. RWR has added nearly $233 million in new assets this year. 

Insurance providers have also been a source of strength this year for the financial services sector. For example, the SPDR S&P Insurance ETF KIE is up 3.7 percent, a surprising move to the upside given that insurance companies are usually positively correlated to rising interest rates.

However, nearly two-thirds of XLF's weight is allocated to banks that would benefit from higher interest rates, underscoring the dichotomy of the current environment facing financial services ETFs.

“All of this creates a mixed environment for financial stocks. Banks and life insurance companies have borne the brunt of this last downshift in interest rates, while real estate firms garnered investor interest. We believe valuations are looking attractive for the financial sector as the market prices in failure of this phase of monetary policy. However, investors should tread with caution. The lack of momentum in financials and the potential impact of NIRP on earnings offset the valuation. This is a headwind these stocks will need to navigate before we would consider aggressively adding them to a portfolio,” adds State Street.

Todd Shriber owns shares of XLF.