In 2017, certain financial services ETFs have received large inflows due to what CFRA sees as increased confidence that macroeconomic and political developments will drive these securities higher. Yet if this were to occur, during a rising interest environment, the outperformance would be different than what occurred in prior rising rate prior periods.
According to Sam Stovall, chief investment strategist at CFRA, during rising rate periods since 1970, the S&P 500 financials sector has traditionally underperformed the S&P 500. He cited the -0.70 correlation between federal funds rate and the yield curve (10-year yield minus the fed funds rate), meaning that when short-term rates rose, the difference between long and short rates fell as inflations fears lessened. This time, however, financial stocks have soared.
Stovall thinks the reasons may be twofold. First, the financial sector is responding to the new president’s pledge to reduce onerous regulatory pressures on the sector. Second, the Fed’s rate-tightening efforts are designed not to “restrain,” but to “recalibrate” the relationship between rates and inflation.
Yield Curve Seen Steepening
Historically, the fed funds rate has averaged about 1.50 percentage points above the year-over-year rise in inflation. Today this relationship would imply that the fed funds rate should hover near 3.8%, not the current sub-1.0% area.
Therefore, Stovall thinks investors likely believe that because of a strengthening economy, the yield curve will steepen, which would ultimately benefit the profit margins of those companies that “borrow short” and “lend long.”
The diversified bank subindustry and regional bank subindustry outperformed the S&P 1500 Index in 2016, climbing 19% and 32%, respectively. Yet CFRA has stars rankings on 40 diversified and regional banks, with strong buys (5 stars) or buy (4 stars) on 14 of them. Bank of America, J.P. Morgan, SunTrust Banks and Signature Bank are some examples.