Financial ETFs Offer Opportunity As Earnings Season Begins

By Tom LydonIndustriesFOXBusiness

While the financial sector has been plagued by misfortunes, with the Brexit as the most recent catalyst, U.S. banks and financial-related exchange traded funds may hold up better than their global counterparts. Investors will also find further insights to how our financial industry is doing this week as the bank-earnings season goes into full swing.

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The Financial Select Sector SPDR (NYSE:XLF), iShares U.S. Financials ETF (NYSE:IYF) and Vanguard Financials ETF (NYSE:VFH) cover one of the worst performing areas of the market of 2016, falling over 2% year-to-date, compared to the S&P 500 Index's 5.8% gain.

"Today's environment is depressing for banks," according to a BlackRock note. "Challenges include low or negative interest rates, regulatory pressures including more stringent requirements, a bad loan hangover from the crisis era in Europe and new competition from 'fintech' disruptors."

The market expectations for another interest-rate increase by the U.S. Federal Reserve have been pushed back, diminishing the outlook for banks' lending margins. Long-term interest rates are back near historic lows, depressing investments in financial instruments like mortgage-backed securities. Meanwhile, trading, underwriting and merger activity may remain muted in a post-Brexit environment.

With all the negatives floating around, U.S. banks are still on more solid footing than their international counterparts. In the U.S., the financial firms have stronger capital positions than their European peers, we have also mostly moved past the regulatory malaise, and there is room for further efficiency and returning capital to shareholders. Moreover, valuations have dropped considerably as banks trade roughly at book value, which may make the sector a cheaper bet compared to other areas.

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"The good news is that values are depressed," Lisa Walker, member of the Global Allocation team for BlackRock Multi-Asset Strategies, said in the note. "In this low-rate and overleveraged world, we prefer high-quality banks with yield, decent return on equity and fee income from non-market related businesses like mortgage origination fees."

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Furthermore, we are still in the midst of an economic expansion, albeit slower than previous years. With the economy growing, loan demand for commercial, industrial, real estate and credit could pick up and help support banks down the line. The historical low long-term rates may even stimulate mortgage lending as more refinance or buy homes. Meanwhile, defaults and write-offs remain at historically lows, which should help limit exposure to the negative effects of toxic debt.

This week, we will get a glimpse of how the financial industry stands, with J.P. Morgan Chase (NYSE:JPM) reporting second quarter earnings on Thursday, followed by Wells Fargo(NYSE:WFC) and Citigroup (NYSE:C) on Friday. The three companies make up almost 20% of XLF's holdings, 15% of IYF and 16.11% of VFH.

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