A Financial Sector Relative Value Trade
No sector has seen its performance turn for the better more than Financials in the last five months.
Financials started the year as the worst-performing sector, lagging the broader markets by over 8 percentage points through July 8, while the hunt for yield and falling interest rates pushed up Utilities and Telecom stocks to outperform the markets by almost 10 percentage points.
GICS Sector Performance of the S&P 500 Index (12/31/15−7/8/16)
But over the last five months, as the 10-Year yield rose from its lows on July 8, this relationship changed and the Utilities sector now has the worst performance over the last five months while Financials are leading the way with rising yields.
GICS Sector Performance of the S&P 500 Index (7/8/16−12/7/16)
The move has been so swift over the last five months that U.S. Financials have changed from being the worst sector to one outperforming the broader gains in the markets by over 10 percentage points.
Because the spike higher in interest rates manifested in strong performance, it may be time to re-evaluate sector rotation.
Where Is There Value in Financials?
There is one market where the Financials sector was down even more going into the bottom of rates and which has not made up all its losses, unlike in the U.S.: Japan.
Going into July, Japanese Financials lost cumulatively 40% from the start of the year.1 There was a remarkable turn, as investors become less bearish on the negative interest rate policy the Bank of Japan instituted in January and a broader pickup in global yields that feeds through to Japanese Financials. Increasingly, Japanese banks have been looking outside of Japan for growth, so a pickup in global yields supports Japanese banks.
Yet the Japanese Financials sector still has not crossed back into positive territory on the year and is still lagging the broader Japanese markets, unlike in the U.S.
WisdomTree Japan Hedged Financials Fund (DXJF) Performance (12/31/15−12/7/16)
Click here for standardized performance of DXJF.
For definitions of indexes in the chart, visit our glossary.
Future Prospects for Japanese Financials
Japanese Financials, from a valuation perspective, appear reasonably priced in our view. On the earnings front, the negative side: there isn’t likely to be any pickup in net interest margins. Unlike the U.S. Federal Reserve, which is hiking rates (albeit slowly), and the 10-Year U.S. rate, which has been rising, the Bank of Japan is very likely to keep a zero cap on its 10-year Japanese government bonds for the foreseeable future.
On the positive side for earnings, though, the contraction of net interest margins is likely over. Loan volumes have the potential to surprise to the upside, in our view, coming from an increase in mortgage lending and small/medium corporate borrowing.
More importantly, net interest margins from overseas lending should exceed expectations, in our view—with potentially a weaker yen and also higher global interest rates.
Finally, non-interest income is also now rising as consumer finance business.
For those investors who have been invested in U.S. Financials recently and have benefited, it may be time to consider rotating into Japanese Financials on a relative value opportunity. At the very least, the performance differentials indicate some interesting spreads to monitor over time.
DXJF Valuation Statistics vs. the MSCI USA Financials Sector Index
as of 11/30/16
For definitions of terms in the chart, visit our glossary.
1Refers to the WisdomTree Japan Hedged Financials Fund (DXJF), 12/31/15–7/8/16.
Important Risks Related to this ArticleThere are risks associated with investing, including possible loss of principal. Foreign investing involves special risks, such as risk of loss from currency fluctuation or political or economic uncertainty. Funds focusing their investments on certain sectors increase their vulnerability to any single economic, regulatory or sector-specific development. This may result in greater share price volatility. The Fund focuses its investments in Japan, thereby increasing the impact of events and developments in Japan that can adversely affect performance. The Fund uses various strategies to attempt to minimize the impact of changes in the Japanese yen against the U.S. dollar, which may not be successful. Investments in derivative investments can be volatile, may be less liquid than securities and may be more sensitive to the effect of varied economic conditions. As this Fund can have a high concentration in some issuers, the Fund can be adversely impacted by changes affecting those issuers. Due to the investment strategy of this Fund it may make higher capital gain distributions than other ETFs. Please read the Fund’s prospectus for specific details regarding the Fund’s risk profile.
Jeremy Schwartz has served as our Global Chief Investment Officer since November 2021 and leads WisdomTree’s investment strategy team in the construction of WisdomTree’s equity Indexes, quantitative active strategies and multi-asset Model Portfolios. Jeremy joined WisdomTree in May 2005 as a Senior Analyst, adding Deputy Director of Research to his responsibilities in February 2007. He served as Director of Research from October 2008 to October 2018 and as Global Head of Research from November 2018 to November 2021. Before joining WisdomTree, he was a head research assistant for Professor Jeremy Siegel and, in 2022, became his co-author on the sixth edition of the book Stocks for the Long Run. Jeremy is also co-author of the Financial Analysts Journal paper “What Happened to the Original Stocks in the S&P 500?” He received his B.S. in economics from The Wharton School of the University of Pennsylvania and hosts the Wharton Business Radio program Behind the Markets on SiriusXM 132. Jeremy is a member of the CFA Society of Philadelphia.