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 (XLF - ETF report) – 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 (MS - Analyst Report) made it the best performer among the financial stocks in August, closely followed by an 11% gain by Bank of America Corporation (BAC -Analyst Report) and 9% rise in Citigroup Inc. (C - Analyst Report) shares. Strong gains in the month significantly helped the financial sector offset majority of the losses incurred since the start of the year.

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.

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.

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