Utilities vs. Financials: A Rising Rates Story

One of the biggest drivers of performance in 2016 has been declining interest rates and all the ramifications across markets and sectors geared both positively and negatively to falling interest rates. Sectors that typically benefit from falling rates tend to be more defensive, higher-dividend-yield sectors often referred to as “bond-like” sectors because of their sensitivity to interest rates. Utilities fit this bill well and have been one of the strongest performers in early 2016. That is, until July 8. The 10-year U.S. interest rate started the year at 2.27% and declined to bottom on July 8 at 1.36%¹. Over that period, Utilities outperformed the S&P 500 significantly. But since July 8, Utilities have been declining and underperformed the market by more than 7 percentage points.²   Reversal of Utilities For definitions of indexes in the chart, visit our glossary. On the opposite side, stocks that tend to get hurt by declining interest rates are often Financials, and this year that ultimately manifested in U.S. Financials but also Japanese Financials in particular. Year-to-date through July 8, U.S. Financials stocks had a slight negative return that was underperforming the S&P 500, but Japanese Financials had a return of -40%, almost twice the loss in the broader Japanese market averages.³   Japanese Financials Taking a Hit Click here for standardized performance of the WisdomTree Japan Hedged Financials Fund (DXJF). Japanese Financials have been hit by a double whammy of a rising yen, which has weakened sentiment to Japan, and declining interest rates. Financials have been a center point for volatility. Since July 8, however, as interest rates increased from their lows, there was a complete reversal of sector performance, with U.S. Financials rising, Japan’s broader markets outperforming the U.S. and Japanese Financials rising even more. The Japanese Financials have pulled back off a surge in August but remain robustly above lows from July 8.   Japan's Financials and Broader Markets Outperforming U.S.   Is This All One Global Rate Trade? The markets have become increasingly correlated to moves in global interest rates. U.S. interest rates move not just with the U.S. economy but by demand for safe-haven assets and low rates globally, as institutions look to escape the low and negative yields in both Europe and Japan. Japanese Financials took a big hit after the Bank of Japan (BOJ) dropped rates into negative territory (NIRP) earlier in 2016. We think the BOJ has shown flexibility in its implementations of NIRP and has attempted to offset the profit hit to banks by trying to steepen the yield curve and providing lower-cost funding to Japanese banks. Further, anticipation of the latest BOJ policy moves steepened the Japanese yield curve and should provide better profits from lending activities. We believe the interest rate environment—particularly the bottoming of rates in July—is supportive for further catch-up of Japanese banks after their dismal start to 2016. If the Utilities sector peaked and faces further downside as a result of a trend toward rising interest rates, we’d encourage investors to rotate into the other side of the low-rate trade and the sector most hit from the falling rates—Japanese Financials, which are among lowest-priced Financials globally. Learn more about the WisdomTree Japan Hedged Financials Fund (DXJF).         ¹Source: Bloomberg, for each period as of 12/31/2015–7/8/2016. ²Source: Bloomberg, as of 7/8/2016–9/14/2016. ³As measured by the MSCI Japan Index or TOPIX Index.