XLF - XLF: 2% Rate Cut Could Be A 2023 Black Swan

2023-07-17 23:25:22 ET

Summary

• The financial sector, represented by the Financial Select Sector SPDR Fund ETF, is attractively valued.
• I see it as a very plausible scenario for interest rates to either stabilize or even decrease.
• Lower rates are especially helpful for bank performance.
• It could also boost the performance of other sub-sectors held in XLF.

Thesis

As seen below, our market dashboard shows that the financial sector, represented by the Financial Select Sector SPDR Fund ETF ( XLF ) is one of the most attractively valued sectors in an otherwise expensive market. By the way, the dashboard is coded as a google-sheet and downloadable via this link: Sector Dashboard . Both in terms of dividend yield Z-score and also yield spread against risk-free interests (represented by 10-year treasury bond rates), the financial sector is ranked the 3rd most attractive sector, only after energy and small caps.

Looking ahead, I see little room for interest rates to further increase from here. Actually, Eric Robertsen, Standard Chartered Bank's Global Head of Research, predicted a rate cut (up to 2%!) to be a top black swan event for 2023. His reasoning is quoted below:

…the FOMC has underestimated the significant damage that rising rates in 2023 will cause to the economy. If the US economy enters a deep recession in the first half of the year, the central bank may switch to a more accommodative monetary policy and cut rates by as much as 200 basis points.

With treasury rates now in the 4%~5% range, an inverted yield curve, and also equity yield spread Z-score all in the negatives (as seen in the chart above), I see his prediction as plausible. And in the remainder of this article, I will detail a bull thesis for XLF based on its reasonable valuation and also the return potential created by a rate cut.

XLF Basics

First, a quick introduction to the ETF itself. XLF aims to track the performance of the financial sector in the United States. The XLF ETF is one of the largest and most popular funds in this space. Its close competitive funds include the Vanguard Financials ETF ( VFH ) and iShares U.S. Financials ETF ( IYF ).

The XLF ETF invests in a diversified portfolio of stocks of companies operating in various sub-sectors of the financial industry. Its portfolio includes banks, insurance companies, asset management firms, credit card companies, and other financial institutions as shown below. For example, as of this writing, the top 5 holdings of XLF are Berkshire Hathaway ( BRK.B ), JPMorgan Chase & Co. ( JPM ), Visa ( V ), Mastercard ( MA ), and Bank of America ( BAC ).

And next, I will explain my outlook on the performance of these stocks in the case of rate stabilization or a decrease.

Impact of Interest Rate on XLF

Before we can analyze the effect of a rate cut on XLF, we should talk about the current interest environment and how that has impacted XLF so far. As is well known, The Fed has been raising interest rates since 2022 to combat rising inflation and overheating of the economy. The Fed has raised the federal funds' target rate range by 325 basis points from 0.25%-0.50% in December 2021 to 5.00%-5.25% in May 2023. And as you can see from the chart below, these rate increases pressured the equity market in general but especially so on the financial sector. To wit, since Jan 2022, XLF has suffered a total loss of 9.6%, compared to SPY's total loss of 3.1%.

Looking ahead, as mentioned above, just like Robertsen, I see several factors that could halt further rate increases or even trigger rate decreases. And for the financial sector, rate decreases are especially welcome news for the various holdings in XLF as introduced above. More specifically, a stable rate or rate decrease can help with:

Net Interest Margin: Banks and other financial institutions, which are a significant component of the XLF ETF, typically earn a portion of their revenue through net interest margin. This refers to the difference between the interest income generated from loans and other interest-earning assets and the interest paid on deposits and other interest-bearing liabilities. As such, when interest rates fall, banks can potentially earn higher interest income, in turn boosting the performance of XLF.

Loan Demand: Interest rates can influence borrowing costs for consumers and businesses. When rates are low, there is often increased demand for loans, as borrowing becomes more affordable. This can stimulate lending activity for many of the financial institutions held in the XLF ETF.

Bond Portfolio Valuations : Financial institutions often hold a significant amount of fixed-income securities, such as bonds, in their investment portfolios. When interest rates rise, the prices of their existing bonds tend to fall, negatively impacting the value of financial institutions' bond holdings. And when rates stabilize or fall, their bond portfolio's worth would stabilize or improve in tandem. Such effects can indirectly boost the performance of the XLF ETF, as it holds shares of financial companies with bond exposure. For example, as of December 2022, US banks had $620 billion of unrealized bond losses. The bond losses vary across different banks, depending on their size, business model, and portfolio composition. Some of the banks with the largest bond exposures include JPMorgan Chase, Bank of America, Goldman Sachs, Morgan Stanley, Charles Schwab Bank, and USAA Federal Savings Bank. And many of these banks are in XLF's portfolio.

Consumer spending. If you recall, two of the top major holdings of XLF are Visa and MasterCard. And both will be affected by stable or lower interest rates the way I see things. Interest rates influence consumer spending, credit card debt, and also default rates. Higher interest rates tend to reduce consumer spending and increase the cost of borrowing, which could lower the demand for credit cards and the volume of transactions. Higher interest rates would also increase the risk of default for cardholders who carry balances, which could hurt the issuers' profitability and willingness to lend.

Risks and final thoughts

Although there are a few challenges facing the banking sector that are worth mentioning now - even if rates do stabilize or decrease. The turbulence caused by regional bank failures may not be over yet. As we all know, Silicon Valley Bank and another two mid-sized regional banks failed during the first-second quarter of this year. The aftermath of these failures in the banking industry could be long-term. For example, the loss of confidence and impact on investors' risk appetite for banking stocks could linger longer. These failures may also prompt regulators to investigate the causes and potentially impose stricter rules and oversight on the financial sector. This may increase the compliance costs and risks for some of the companies in XLF's portfolio. Finally, the competitive pressures from fintech companies could disrupt the traditional financial services industry with their innovative products and platforms.

All told, my overall view is that the positives outweigh the negatives, especially under the current conditions. And to recap, the key positives are twofold. First, I see a very reasonable valuation amid an otherwise very expensive market. I analyzed the valuation in terms of the yield spread above. The chart below shows the valuation in terms of the commonly quoted multiples. As seen, XLF currently trades at 14.3x P/E and 9.76x P/cash ratio, very reasonable both in absolute and relative terms. Second, I see a stable rate or a rate cut as a very likely scenario, which would be especially helpful to the various sub-sectors held in XLF as analyzed in the 3rd section above.

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