Along with other sector exchange traded funds, the Financial Select Sector SPDR (NYSEArca: XLF), the largest financial services ETF, has pulled back in recent days, but many market observers maintain the view that 2018 could be another strong year for the S&P 500’s second-largest sector weight.
Capital levels at major U.S. banks are viewed as solid. Additionally, the Trump Administration’s tax reform effort is seen as a potential catalyst for the financial services sector, but it remains to be seen if that effort will come to life. Some industry observers expect the tax reform would help banks boost earnings in significant fashion.
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“In addition, the corporate tax rate deduction included in the ‘Tax Cuts and Jobs Act’ provides a tailwind for bank earnings,” said State Street in a recent note. “Banks, on average, currently pay a 30% tax rate; the new tax bill will lower the corporate tax rate to 21%. A simple calculation indicates this could potentially save US banks 30% on taxes and boost earnings by 13%.”
Deregulation could also help the financial sector improve their margins. President Donald Trump has shown its eagerness in cutting back the red tape and remove some of the post-financial crisis regulations that has stifled the industry.
“As a result of stricter capital requirements placed on banks in the wake of the financial crisis, Morgan Stanley estimates that US banks are sitting on about $130 billion of excess capital, representing around 8% of the total market capitalization of the bank segment of the S&P 500,” according to State Street.
If that cash is freed up, it could mean higher dividends and buybacks for bank stocks and ETFs.
Some good news for XLF and friends is that the financial services sector is widely regarded as perhaps the only sector in the U.S. that is attractively valued relative to the broader market and its own long-term averages. The financial sector valuations still look relatively cheap, compared to the broader market. The sector’s valuations are still about 25% below the average since the early 1990s.
“However, even with the boost in their returns to shareholders and improved profitability, bank stocks lagged the broader market by a large margin in 2017,” said State Street. “The S&P Bank Select Industry Index returned 10.7% last year, compared with a 21.8% return for the S&P 500. Despite the aforementioned tailwinds that could drive this sector, the following chart shows that bank valuations are still below historical averages relative to the broader market.”
For more information on the financial sector, visit our financial category.