A Bounty With Bank ETFs? Maybe

Investors' frustration with the financial services sector could be nearing its end. Even with two interest rate hikes by the Federal Reserve, the sector has been a laggard for much of this year, but some market observers see that trend drawing to a close.

Some exchange-traded funds seem to concur. For example, the iShares U.S. Financial Services ETF (NYSE:IYG) is up 3 percent this month, bringing its year-to-date gain to north of 11 percent. The $1.3 billion IYG and rival bank-heavy ETFs are showing signs of momentum and that is where investors want to be: With ETFs heavily allocated to bank stocks. IYG fits the bill as 56 percent of its 116 holdings are banks.

U.S. banks have lagged the broader market and European peers year-to-date, said BlackRock in a recent note. We believe this trend has turned. We see the group up in the medium term on sustained economic growth Federal Reserve (Fed) normalization and prospects for deregulation and payouts.

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It's About More Than Just Interest Rates

The bullish thesis on bank stocks revolves around more than just the Fed's monetary policy. That is helpful to ETFs such as IYG. IYG allocates over 20 percent of its combined weight to Dow component JPMorgan Chase & Co. (NYSE:JPM) and Bank of America Corp (NYSE:BAC). Wells Fargo & Co (NYSE:WFC), US Bancorp (NYSE:USB) and Goldman Sachs Group Inc (NYSE:GS) are among the ETF's other top 10 holdings.

Theres more to U.S. bank stock performance than interest rates, we believe, said BlackRock. Higher rates tend to help banks profitability, and correlate with better share price performance. But U.S. bank stocks shot up in late June even as the expected change in the federal funds rate slumped. Why? An annual stress test had cleared the biggest U.S. banks, raising investor hopes for more stock buybacks and dividend payouts.

IYG has a trailing 12-month dividend yield of just 1.25 percent. However, many of the ETF's holdings have, in recent years, shown an overt commitment to boosting buybacks and dividends.

Earnings, Too

Adding to the non-Fed catalysts for bank stocks are some solid earnings growth projections, which could be enhanced by a steepening yield curve.

Analysts expect U.S. bank earnings to grow 12.8 percent in 2018, said BlackRock. We see scope for this number to improve. Global banks as a group are trading at a bigger discount to the broader market than their 10-year average, with U.S. banks discounted by 24 percent compared to 5 percent for European banks.