Financials are historically the best performers during a period of rising rates, but as interest rates have risen this year, the big-cap financial sector has declined.
Still, many analysts continue to favor them as a top pick because they believe what ails them will go away and higher rates will make a difference. The S&P financial sector is down a half percent this week so far, and it's still negative for the year-to-date, off 0.7 percent.
"We're overweight the group. We like the group. The most important thing is if people make their loan payments or credit performance. The answer is it's pristine, fantastic," said Jonathan Golub, chief U.S. equity strategist at Credit Suisse.
"Things aren't perfect. Loan growth is a little disappointing. I think it will get better. What we've had in almost two years is a near doubling of interest rates, which is an enormous help to financials," he added.
Golub studied the impact of rising interest rates on stocks in an analysis which looked strictly at days when rates rose versus performance when rates declined. He said the overall was higher when the 10-year yield increased, but financials outperformed by a wide margin, even doubling the second-best performing group, materials.
Over 12 months beginning in March 2017, the financial sector would have been up 61.8 percent if it was held only on days when the 10-year yield advanced. On days that the benchmark yield was lower, the group declined 27 percent. The S&P 500 would have been up 24 percent on days when the yield rose. Mathematically, Golub said, that's proof positive that financials and stocks do better when long-end rates rise.
Sector performance over 1 year from March 2017
Source: Credit Suisse
But in the market most recently, financials have fumbled even as the 10-year Treasury yield, which impacts mortgages and other longer term loans, has bumped up against 3 percent this week, from 2.40 percent at the end of 2017. That should mean banks can capture that higher yield on loans they grant, but the problem is short-term rates have risen faster and the yield curve has been flattening.
"Not everything works according to script all the time," Golub said. "What we also know is the financials don't do well when there's concerns about the yield curve flattening. Normally when rates are rising like they have been there's this belief that the yield curve is steepening."
At the short end, the has climbed to about 2.49 percent, about 50 basis points, or half a percentage point, away from the 10-year yield. The spread between them has been flattening and some fear it will invert, or rise above the 10-year yield. That inversion has been a reliable signal of an oncoming recession.
This week, the yield curve has steepened slightly and is about 8 basis points above last week's low, which was the flattest it's been since 2007. The move up in the 10-year yield, now at 2.99 percent, has helped.
"Our analysts think [financials] will do better because the feeling is we are going to maintain a positively sloped yield curve and even see a widening yield curve," said Sam Stovall, chief investment strategist at CFRA. "What's been happening is loan growth is pretty anemic."
With a flatter yield curve, financials "have to pay more for the capital they will then turn around and lend out," Stovall said. He said the Fed's reversal of its asset purchase program should help push up the 10-year yield. The Fed has been decreasing the level of bonds it had purchased in an effort to stimulate the economy.
The stock market this year has had its bumps as yields edged up, particularly when the 10-year yield rises. The S&P 500 is flattish after lots of volatility in the past five sessions. During that time, the Financial Select Sector SPDR ETF is down about 0.6 percent.
"It's pretty clear that the market is much more sensitive to the long end of the curve. What it really says is the market, as much as everybody talks about the Fed, the market cares a lot less about them than it cares about the the general level of rates in the economy that the markets set themselves," Golub said.
Golub said financials should also benefit from deregulation, and were big beneficiaries of the tax law changes. The stocks underperformed in a quarter where earnings were up more than 20 percent.
"In the earnings releases, some banks did well on their earnings number and didn't get a good response," Golub said. He said some banks did well because of volatility and trading was strong, not something that will necessarily reoccur.
"Credit performance is unbelievable which is great news ... but there's a lot of discussions investors are having that things are so ridiculously good, people are saying it can't get any better. This is a gold medal quarter," he said.
Golub said financials earnings may not do as well as they did in the first quarter, but for now they look strong.
He also said it's a myth that stocks can't do well with rising rates, though he sees a 3.5 percent 10-year as the starting point of a zone of where stocks could start to run into trouble.
"What the market would like is [rates moving] slowly higher in a more stable way," he said. "I think what most people think is 3.5 percent is a precipice, so when you go past there all hell is going to break loose and the market is going to fall apart. What the data shows is 3.5 is a point where rates begin to be a negative — 3.5 is a neutral point as opposed to being a cliff," he said.
But when the 10-year crosses above 4 percent, that could be an issue for stocks, he said.
"Here's the most important thing for investors to focus on ... as long as the economy is healthy and moving forward, the likelihood of recession in the next 12 to 18 months is below average, the markets tend to go up much more than people estimate," he said. Golub said that even if the curve flattens but the economy looks good, he would see it as a buying opportunity for stocks.