Stressed Out

by Jason Norris, CFA
Executive Vice President of Research

Over the last month, financials and industrials have been the two worst performing sectors in the S&P 500. While the industrials sector can be explained due to the strengthening U.S. dollar and trade rhetoric, financials have been more perplexing.

Fears in the sector are stemming from a flattening of the yield curve, which occurs when short-term interest rates rise and long-term rates fall. Over the last month, short-term rates (i.e., two-year Treasury yield) remained steady at a 2.52 percent yield. The 10-year Treasury yield fell slightly from 2.92 percent to 2.84 percent and long-term rates are still meaningfully higher than they were at the beginning of the year. As a result, we experienced a 13-day losing streak in financials that finally ended this week. Historically, financials stocks perform well when rates are rising, but this month we did not see this relationship play out. The other notable time this occurred was from 1998 to 2000, which was another large-cap growth market. During our aforementioned 13-day losing streak, investors sold $1.8 billion SPDR Financials ETFs, called the XLF, as seen in the chart below. So, is this the tail wagging the dog?



We anticipate rates moving higher as GDP and wage growth remain and the U.S. budget deficit continues to widen. We expect the 10-year Treasury to finish the year close to 3.25 percent.

Friday marked the end of the financials losing streak, following the release of the Federal Reserve’s Comprehensive Capital Analysis and Review, which shares results of bans’ stress tests. The Federal Reserve gave passing grades to 34 out of 35 banks, with Deutsche Bank U.S.A. receiving the failing grade. Thirty-two of the banks that passed were allowed to increase their capital return programs. Morgan Stanley and Goldman Sachs were instructed to maintain, not increase, their programs.

The bullish result of the stress tests was the wave of dividend increases. The 32 financial institutions raised their dividends by 25 percent on average. Six banks, JP Morgan, Citigroup, Key Bank, Santander Consumer, Regions Financial and Citizens Financial, increased their dividend by over 40 percent. Our anticipation of strengthening balance sheets was one of the reasons we were overweight financials. These stress test results, tax cuts and rising rates will foster positive returns for this sector.

Week in Review and Our Takeaways

  • The week started with a tariff tantrum with news about China, autos, and Harley Davidson production changes. Even though the headlines subsided, they weighed on equities, resulting in the S&P 500 falling 1 percent for the week
  • Investors did “de-risk” their portfolios by selling the winners in technology, which was the worst performing sector of the week. The spike in oil prices helped energy shares finish up 4 percent as well
  • While financials have lagged the market, we believe fundamentals still warrant an overweight to the sector
  • Trade fears continue to result in short-term volatility for equity markets.