A Split Outlook for Bank ETFs (XLF)

The Financial Select Sector SPDR (XLF), the largest exchange-traded fund (ETF) tracking the financial services sector, is off 2.1 percent over the past week. That decline is enough to turn the ETF negative on a year-to-date basis and enough to remind investors that the S&P 500’s second largest sector weight has been a disappointment this year.

Financial services stocks and ETFs were expected to benefit from the Federal Reserve boosting interest rates, which it did in March. However, the Fed was surprisingly dovish​, a tone that took some of the air out of the financial services sector. That deflating spirit has carried over to the current quarter, with XLF slumping more than 5 percent. Currently languishing below its 20- and 50-day moving averages, XLF is not far from entering an official correction. (See also: Why Stocks Could Fall 20%: A Technical View.)

There are differing views on the sector. Some analysts believe that financials are seeing more good news than bad, but they caution that stock prices currently reflect that sanguine outlook. “For the first time in a long time, good news is starting to outweigh bad news for banks,” said Morningstar. “However, the good news is more than reflected in the stock price, and there’s a little bit of room for caution.”

The Fed has already disappointed investors in XLF and rival financial services ETFs, and with the outlook for more rate hikes this year dwindling, investors may want to consider financials that are less correlated to higher interest rates. Morningstar recommends Citigroup Inc. (C) and Wells Fargo & Company (WFC). “We favor the stocks that are less sensitive to interest rates – Wells Fargo and Citigroup,” said Morningstar. “Both of those stocks have had some problems in years past. Wells Fargo had a sales scandal in the fall of 2016; Citigroup has obviously been struggling for a long time. But both of those stocks are starting to recover. Well Fargo’s customers have stopped leaving, accounts are stable at Wells at the moment, and the dividend yield is approaching 3 percent. Similarly, Citigroup had a great first quarter. Expenses are under control, and revenues are starting to rise again.”

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Wells Fargo and Citigroup combine for over 14 percent of XLF’s weight, but the ETF has plenty of constituents that are sensitive to interest rates. For example, XLF devotes nearly 45 percent of its roster to banks, plenty of which would benefit from higher interest rates. Additionally, XLF allocates over 19 percent of its weight to insurance providers, another segment of the broader financial space that often benefits when the Fed hikes rates. (See also: How Interest Rates Affect the US Markets.)

Another potential stumbling block for XLF and comparable ETFs is the Trump Administration’s ability to push forward with its tax reform efforts. That plan was widely expected to boost financial stocks, but with doubts increasing that the White House has the political capital to push forward marquee parts of its agenda, financial stocks could suffer more setbacks. (See also: Opinion: Will Donald Trump’s Tax Reforms Reform Anything?)

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