3 Sectors That Need Fed To Raise Rates

Hedge funds have been buying into financials in recent months, looking for the sector to benefit from higher rates ahead, Ilya Feygin, managing director at WallachBeth Capital, tells us. Going forward, he says Fed action will be crucial in determining not only the outlook for this sector but for health care and technology, as well. Think funds such as the Financial Select Sector SPDR Fund (XLF | A-91), the Health Care Select Sector SPDR Fund (XLV | A-96) and the Technology Select Sector SPDR Fund (XLK | A-89).

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ETF.com: Hedge funds have been buying up financials. What’s driving that demand?

Ilya Feygin: In recent weeks, hedge funds have been increasing their financial exposure because they looked interesting to them on a fundamental basis. They looked at their earnings projections, they looked at valuation measures that were lower than other large-cap stocks in their universe.

But the financial sector has really been driven by interest-rate expectations. If you look at the beginning of this year, in terms of the Fed funds market, it was pricing in over 1.5 percent for the forward Fed funds in December 2016. That's the rate I look at, and that's come down about 50 basis points since then.

The tightening that was projected for the Fed has really come down from those low points. The relative performance of financials has been very much a function of interest rates. They will greatly benefit when the actual Fed funds rate rises.

This movement hasn’t been only into financials. Health care has attracted a fair amount of money; tech as well. Those have really been the big three sectors. They're really the largest sectors in the S&P right now. They're more than 50 percent of the market cap and they've been a big driver of performance.

ETF.com: Are valuations in financials still below long-term historical levels? Is it still an attractive risk asset to own from a valuation point of view?

Feygin: To a much lesser extent. I think that argument was very strong when the rally first started in 2011 and 2012. There were a lot of financial names that were trading at 10 times their earnings. That's no longer the case. The sector as a whole is trading at almost 15 times forward earnings, which is more attractive than other sectors, but it doesn’t offer tremendous longer-term value.

The Financial Select SPDR (XLF | A-91) has struggled around this $25 area for that reason. That's a resistance area, which I think corresponds to closer to 15 times earnings, roughly, give or take.

It’s a multimonth double top, and I think the sector's going to have trouble getting above that in the short term, especially with only a just-over 1 percent Fed funds now priced in for December 2016. You need more than that to really get upside in that sector because that's pricing in at a very, very gradual pace of tightening.

ETF.com: Does that mean that the uptick in demand for these sectors is going to slow down going forward until we have a stronger signal from the Fed?

Feygin: I think so. If at the end of the summer—which is kind of the road map that the Fed has laid out for us—they're not ready to signal a hike in either September or December, that's going to be disappointing for the sector because the sector needs an actual hike. It can't just have expectations of some day having a hike.

In financials, just staying around the $25 area on XLF already means pricing that expectation, which needs to be fulfilled. There's not much room for error up here.

ETF.com: Do you think that hedge funds have generally a positive outlook on the U.S. economy?

Feygin: Yes. You have to have a positive outlook if you're betting that the Fed will do anything substantial. Because if the economy does not bounce back by the end of the summer, then the Fed is going to be extremely slow.

ETF.com: And that would trigger a correction in financials?

Feygin: It will, absolutely. Maybe not a very large one, but they will underperform the rest of the market.