How Much Fuel Is Left In The Financials 'Gas Tank'?

| About: Financial Select (XLF)

Summary

Financials have outperformed defensives and other non-financial sectors in the last couple of months.

Expectations about a steeper yield curve and widening net interest margins benefit financials.

Macro and technical backdrop suggest that financials will continue to outperform unless an exogenous global deflationary shock hits the global economy.

A couple of months ago, an opportunity for U.S. financials (NYSEARCA:XLF) to outperform some non-financial sectors had emerged due to the Fed's tug-of-war on interest rates; a market scenario which actually came true. The expectations for higher interest rates in the U.S., as a reaction to the improving global macro fundamentals, have been the driving force behind this outperformance. This made investors expect a recovery of net interest margins, which are the "oxygen" of banks, from their historically low levels. Since the outperformance trend of financials versus defensives has already covered some ground since its inception, it is very critical to ask if this trend has more "fuel" to "burn." Judging from the looks of the current macroeconomic and technical dynamics this trend seems capable to extend itself, unless of course an unpredictable exogenous shock abruptly deflates the global economy.

Synthetic Trade Performance

The trade opportunity discussed in late July involved a synthetic position consisting of long financials, and an equal-sized short position split between utilities (NYSEARCA:XLU), consumer staples (NYSEARCA:XLP), REITs (NYSEARCA:VNQ), Industrials (NYSEARCA:XLI) and high-yielding dividend stocks (NYSEARCA:DVY). Financials have, in fact, outperformed every one of these sectors since, allowing this synthetic trade to produce some meaningful gains. On the one hand, the Utilities and REIT sectors produced the biggest losses, by dropping 10.5% and 10.3% respectively, and on the other hand the financials produced a 2.3% gain. Are these divergent trends expected to continue? Only an analysis of current macro and technical fundamentals can provide the answer.

Trade

Source: tradingview.com, author.

How Interest Rate Developments Benefited Financials?

Despite the fact that the Fed hasn't pulled the trigger on interest rates yet, markets have covered much ground when it comes to adjusting their expectations. The U.S. yield curve has steepened modestly since August, with the 10-to-2-Year yield difference climbing to 0.90% from 0.76% that it was in late August. Long-term yields have been rising much faster than short-term ones. Banks and insurers can certainly benefit from such a development, as they can now find higher long-term yields available to invest their money in. Banks borrow money based on short-term rates - mainly deposits - and base their investments on long-term rates, for example providing fixed-rate mortgages. Insurers, on the other hand, need as high long-term rates as possible so they can match their long-term liabilities with their interest bearing assets. For these beneficial trends to keep going, the macro backdrop should continue to be supportive.

Macroeconomic Background

The latest macro releases for the U.S. economy exhibited a steady but slow-growth cycle of recovery for Q3, and kept the door open for the next interest rate hike by the Fed. Even though the U.S. doesn't seem to be the locomotive of the world economy any more, there is another region which fuels the optimism in the long end of the yield curve. Asia seems to be ready to reverse its soft-landing cycle, assisted by a series of expansionary monetary policies. China, in particular, has exhibited resilience in all of its latest macro releases, and could potentially drive global demand up in the weeks and months to come. The long-end of the U.S. yield curve is anchored to global developments while the front end ebbs and flows with the Fed's tug-of-war on interest rates. This combination allows the U.S. yield curve to become steeper and interest margins to widen. Financials can reap the benefits of these widening interest margins, along the way.

Technical Perspective

Apart from the constructive macro backdrop, the ratio of financials over utilities (XLF/XLU), which shows how the former perform in relation to the latter, has formed a major head and shoulders bottom formation throughout this year. The recent break to the upside of this formation's neckline not only signaled the beginning of a new strong uptrend but also provided a new target (Target A).

XLF vs XLU

Source: tradingview.com

The ratios of financials over consumer staples (XLF/XLP) and REITs (XLF/VNQ) have followed a similar technical pattern, whereas the ratios between financials and high-yielding stocks (XLF/DVY), as well as financials and industrials (XLF/XLI), have not followed suit. Their long-term downtrend lines are still very much intact, which is why it is very important to monitor these two ratios closely since they too might break to the upside. If this happens it will reveal a generalized outperformance of financials.

XLF/XLI

Source: tradingview.com

Risk Assessment

Even though these macro and technical indications are solid investors should not ignore the risk of such a synthetic strategy, which is none other than an exogenous shock to the global economy. Such a shock could reverse current expectations for a reflationary global environment, and drive the yield curve back to a flattening mode. This would also produce a burst of volatility in equities, with financials taking the biggest hit. A potential hedging tactic against such an adverse market scenario would be to buy call options on the Japanese yen. The Japanese yen is the safe haven asset, which in fact has multiple reasons to strengthen, either during the current sanguine financial environment or under an abrupt reversal of it. In the case of a global risk-off the yen (NYSEARCA:FXY) could break its long-standing 100 USDJPY resistance and produce some sizable gains.

Assuming that a relatively smooth recovery of the global economy continues, and inflationary expectations gradually build up, financials seem perfectly positioned to continue benefiting the most in contrast with defensives and other select non-financial sectors. Technical dynamics point clearly to that direction, as well as macroeconomic ones. In any case, investors who would like to stay on board should apply some smart hedging tactics in order to brace themselves against a sudden world changing even that has the capacity to bring expectations upside down. Irrespective of the source of such a shock, be it a Chinese FX crisis, or the implosion of the European banking sector, investors who bet on financials should shield themselves with some smart hedging.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: The views expressed in this article are solely those of the author, provided solely for informative purposes and in no case constitute investment advice.