XLF: Why Financials Are Outperforming Now

Financials led all other sectors Wednesday as the Financial Select Sector SPDR ETF (XLF) jumped 6% and Donald Trump’s victory solidified its growth potential in a higher-for-longer environment.  

Financials’ dominance extends to the past month as the sector has returned 8.5%, while the S&P 500 has gained 3.1%. 

Can this recent outperformance be attributed to Trump’s decisive win in the presidential election, or are there more contributing factors? What might derail the financial sector rally? 

Why XLF and Financial Stocks Are Outperforming

The XLF ETF is likely outperforming other stock sectors due to a combination of factors: 

Higher-for-longer rates: Economic reports revealing a resilient consumer and sticky inflation support higher interest rates, which typically benefits banks, as banks benefit from wider net interest margins, enhancing profitability.  

• Economic recovery: A strong economic recovery can boost the performance of financial institutions. As the economy grows, banks and other financial companies tend to benefit from increased lending activity and higher fees. 
• Regulatory tailwinds: Favorable regulatory changes attributed to a Trump win and a GOP-led Congress can also positively impact the financial sector. 
• Investor sentiment: Positive investor sentiment towards the financial sector can drive demand for financial stocks, including those in the XLF ETF. 

Further, economic indicators hinting at a "soft landing" for the economy—where growth slows without tipping into a recession—have buoyed financial stocks. The resilience in consumer spending and corporate profits reduces recession risks, which had weighed on banks and insurers earlier in the year. This optimism also aligns with expectations that any future rate hikes may be more moderate, reducing the pressure on financial institutions from potential credit defaults  

Some analysts also note that financial stocks have been relatively undervalued, so recent gains may represent a "catch-up" effect as investors allocate capital into perceived bargains within the sector.

XLF One-Month Price Movement

What Could Go Wrong for Financials? 

The financial sector faces several potential challenges that could impact its performance:

• Interest rate risks: While high-interest rates benefit banks' lending margins, they also increase the risk of loan defaults, especially if rates stay high for an extended period. Consumer and corporate borrowers facing higher interest costs might struggle to meet debt obligations, raising concerns over credit quality and possible losses on loans. 
• Economic slowdown or recession: If the economy weakens, banks may see slower loan demand, and defaults could rise as businesses and individuals experience financial strain. Even a "soft landing" that reduces economic activity could limit financial institutions' growth opportunities.  
• Market volatility: Financial stocks are sensitive to overall market sentiment and volatility. Sudden market downturns, geopolitical tensions, or unexpected policy shifts can lead to fluctuations in stock values. 
• Technological disruption: The rise of fintech companies and digital banking poses a competitive threat to traditional banks. While many financial institutions are adopting technology, those slower to adapt could lose market share to more agile, tech-driven competitors. 
• Global economic conditions: Financial stocks are influenced by global economic trends. For example, issues like China’s economic slowdown or Europe’s financial challenges can create ripple effects, affecting U.S. financial stocks by impacting global credit markets and investor confidence. 

These challenges, combined with the cyclical nature of financial stocks, suggest that while the sector may currently outperform in certain conditions, these factors present substantial long-term risks.