Why Bank ETFs May Need a Rest

This article was originally published on ETFTrends.com.

The Financial Select Sector SPDR (NYSEArca: XLF), the largest exchange traded fund tracking the financial services sector, and rival financial services ETFs have been solid performers dating back to last year. For example, XLF is up 18% over the past 12 months.

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.

However, some market observers believe banks stocks may need a short-term breather before climbing higher.

“Many of the names we cover have had total returns for shareholders of 20% all the way up to 70% over the last two years,” said Morningstar. “For an industry which has traditionally grown tangible book value in the mid- to upper-single-digit-range, with range-bound margins and returns on equity, this does not seem sustainable to us.”

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.

“With tax cuts being written into law, good reasons to expect more economic growth, regulatory relief already playing out, and a normalizing interest-rate environment, the near-term outlook for regional bank performance is certainly positive,” said Morningstar. “Incorporating these factors has caused our fair value estimates to increase across the board this year. The largest factors contributing to this change were the corporate tax rate dropping to 21%, this was from our previous assumption of a drop to 25%, as well as updated leverage assumptions, as we believe banks will now begin to shed the excess capital that they have built up in response to the post-crisis regulatory environment.”

Year-to-date, investors have pulled nearly $744 million from XLF after adding $5.59 billion to the fund last year.

“We believe that banking is in many ways a commoditized industry and that over time, increasing wage pressure, increasing competition for credit and deposits, and an eventual turning in the credit cycle will all keep returns on equity from expanding indefinitely. This will limit returns over the medium term in our view,” said Morningstar.

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