What's Behind The Bank ETF's Rally?

Financial services, one of 2018's worst-performing sectors, is looking to shed that laggard status this year. The group is off to a good start, as highlighted by the Financial Select Sector SPDR XLF, which is up 9.15 percent year-to-date.

Bank stocks — often biggest percentages of broad financial funds like XLF — are leading the way. The SPDR S&P Bank ETF KBE is higher by almost 15 percent to start 2019.

What Happened

A glaring reason why financials disappointed last year was that the Federal Reserve obliged by raising interest rates four times, but the flatter yield curve plagued bank stocks and exchange traded funds like KBE and XLF.

“Unfortunately, the flattening yield curve spoiled financials’ fun in 2018,” State Street said in a recent research piece.

“Most financial companies earn profits by borrowing from demand deposits like savings and checking accounts that pay depositors a low interest rate while lending longer term at higher rates through mortgages and business and consumer loans. The wider the spread between the interest rate financial companies pay depositors versus the interest rate they collect on the loans, the greater the profit.”

Yield curve-driven disappointed prompted investors to pull $5.35 billion from XLF last year. KBE saw 2018 outflows of $606.57 million.

Why It's Important

Entering this year, financials were an unloved corner of the market, but the sector is cheap on valuation — and if short-term rates decline, investors could revisit funds such as KBE and XLF.

“Trading at an eye-popping 55-percent 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,” State Street said. 

Sectors are sometimes cheap, but with unattractive earnings growth; financial services earnings growth actually looks good.

“Year-over-year net profit margins for financials are likely to eclipse 16 percent, more than 5-percent greater than the year-over-year net profit margin of the market and the third highest of the 11 economic sectors,” according to State Street. 

What's Next

In order for financials to build on January gains, some assistance from the yield curve would be beneficial. Two-year Treasury yields are declining, and that's a start. 

“The yield curve may not flatten as much as investors are expecting,” according to State Street. “Maybe it will even steepen some this year and unexpectedly boost financials’ profitability.”

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