Financial ETFs Surged In August: Will The Rally Last?

While most of the major U.S. benchmarks found it difficult to finish in the positive territory in August, it was the financial sector that outperformed other broader S&P 500 sectors. Rising possibilities of a rate hike on the back of an improving U.S. economy played a major role in boosting the sector last month. The broader financial sector ETF – Financial Select Sector SPDR ETF (NYSE:XLF) XLF – gained nearly 3.9% and emerged as the best performing sector.

Meanwhile, the KBW Nasdaq Bank Index that seeks to track performances of bank stocks surged 6.8%. Moreover, major U.S. banks recorded significant gains last month. A 12% rise in shares of Morgan Stanley (NYSE:MS) made it the best performer among the financial stocks in August, closely followed by an 11% gain by Bank of America (NYSE:BAC) Corporation (NYSE:C) and 9% rise in Citigroup Inc. (NYSE:C) shares. Strong gains in the month significantly helped the financial sector offset majority of the losses incurred since the start of the year (read more: U.S. Banks Clear Stress Test: Financial ETFs in Focus).

Rate Hike Chances – Main Catalyst

Fed chairwoman Janet Yellen recently said that “the case for an increase in the federal funds rate has strengthened in recent months” on the back of an improving U.S. economic scenario. Moreover, other Fed officials remained in favor of a rate hike in the near term. Recent comments by the Fed Vice Chairman Stanley Fisher, the New York Fed President William Dudley and the Atlanta Fed President Dennis Lockhart indicated that the underlying strength in the U.S. economy is favorable enough to sustain a rate hike by the end of this year (read: Hawkish Fed Vice Chairman Adds Strength to These ETFs).

Except REITs, the other Finance sector constituents – banks, brokerage firms, asset managers and insurers – usually benefit from a rising rate environment. This is because the steepening yield curve tends to bolster profits for banks, insurance companies, discount brokerage firms and asset managers. Moreover, second-quarter performances of the finance companies were encouraging in spite of a challenging operating environment. Effective cost management and exploration of different options to improve the top line helped these companies maintain bottom-line growth during the quarter.

Will the Surge Continue?

Performances of financial ETFs in the near future will largely depend on the rate hike prospects, which in turn are contingent on inflation rate and labor market conditions in the near term. In her speech at Jackson Hole, Yellen stated that the central bank currently predicts that the U.S. economy will continue to witness encouraging growth and the labor market is poised to be favorable in the coming months. She also said that the Fed sees “inflation rising to 2% over the next few years” (read: Is it Time to Invest in Financial ETFs?).

Banking on this encouraging outlook, the central bank “continues to anticipate gradual increases in the federal funds rate will be appropriate over time.” Meanwhile, today’s official jobs data is likely to play an important role in rate hike decisions. A better-than-expected private sector employment report released on August 31 has bolstered chances of a rate hike.

According to the Automatic Data Processing Inc. (NASDAQ:ADP) , about 177,000 jobs were added in the private sector in August, more than analysts’ expectations of 175,000 job additions. Private payrolls data for July was also raised to 194,000 from 179,000. Moreover, outcome of the U.S. presidential election in November are expected to be an important factor for the rate hike. Though the probability of a rate increase in September currently stands at 24%, there lies a 57% possibility of a December hike, as per CME Group (NASDAQ:CME) (read: Fed or Trump: Who Will Decide the Fate of Gold ETFs?).

Financial ETFs to Watch

In addition to the broader financial ETF, XLF, other popular ETFs from this space reported significant gains last month. Vanguard Financials ETF VFH and iShares US Financials IYF rose 3.2% and 3.2%, respectively, in August. Moreover, two popular bank ETFs surged last month on the back of rising rate hike speculations. Further, SPDR S&P Bank ETF KBE and SPDR S&P Regional Banking ETF (CO:KRE) rallied 7.3% and 3.4%, respectively, last month. These funds are also poised to remain on investor radar in the coming months as investors will closely watch for cues of a rate hike.

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