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Will Trump & Fed Make 2017 a Year of Financials ETFs?

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It seems that the days of increased regulatory scrutiny are over for U.S. financial stocks. The signing of an executive order by President Donald Trump to scale down regulations on the financial industry recently gave a nice bounce to its already in-demand stocks (read: Trump & Earnings Effect: Hit and Flop ETFs of Last Week).

Investors should note that President Trump is eyeing to phase out the 2010 Dodd-Frank financial-overhaul law – one of the regulations undertaken in the height of the 2008 financial crisis. The focus of the law was to cut back on uncontrolled lending and avoid the situation where tax-payers’ money is needed to bail out large financial institutions.

The Act led the finance sector companies to divest risky operations. It also raised operating expenses of financial institutions given the rise in compliance costs. Further, stringent capital requirements led banks to curb investments. The President now wants the Treasury Department to review the Act and file a report in four months on possible regulatory alterations.

Trump also plans additional executive action targeted at withdrawing a regulation slated to be effected in April. This regulation instructs retirement advisers, supervising nearly $3 trillion in assets, to operate businesses in the best interest of their clients. If this rule is withdrawn, the retirement-account advisory business would be able to price products freely and offer consumers various choices, as per analysts. Needless to say, profitability of the advisory businesses wouldn’t be hurt.

Market Impact

The initial impact was a rally in financial stocks on February 3, 2017. However, financial shares were a little down in trading that followed. The largest financial ETF Financial Select Sector SPDR (XLF - Free Report) added over 2% on February 3, 2017 while the fund dropped about 0.7% in the next two trading sessions (read: Should You Buy Bank ETFs on the Dip?).

What Lies Ahead?

We would like to note that may be the repeal of regulatory stringency would give banks leeway for more profits ahead, but the health of the financial institutions nothing but improved in all these tough years. At the same time, chances of defaults in the banking system lessened.

Major banks are likely to come up with strong earnings reports in the ongoing reporting cycle with 12.5% expected earnings growth. Insurance should give a superb performance with 26.2% earnings growth while banks & thrifts are likely to post 23.7% expansion in earnings. Investment banks is expected to record a 15% expansion in earnings in Q4 of 2016, as per Earnings Trends issued on February 1, 2017. If things are already in a decent shape, it is to be seen now how Trump’s policies are digested by consumers.

Hopes of easing relations and increased inflationary expectations, which translated into higher treasury yields, and the Fed’s policy tightening benefited the sector in recent times. However, uncertainty regarding how successful and accepted Trump’s policies will be in the coming days and geopolitical concerns especially in Europe may flare up risk-off trade sentiments. This in turn will pull down U.S. Treasury yields, spoiling the positive mood in financial stock investments. Notably, these stocks perform well in a rising rate environment.

The energy sector is another area to be watched. Weakness in energy has been the key drag on the banking sector. This is because U.S. banks have significant exposure to the long-ailing energy sector where chances of a credit default were high. Now with oil prices stabilizing following the OPEC output cut deal, things are taking a turn for the better (read: Solid Sector Earnings Fail to Boost Energy ETFs).

Then again, a few analysts are hopeful that withdrawal of strict regulations should further boost earnings power of banks which in turn would help them offer more dividends or repurchase shares. These activities in turn should enahnce shareholders’ wealth.

Bottom Line

Several factors are in play right now for financial stocks like Trump, Fed, oil, geopolitics, consumer sentiments and how banks deploy savings from expected regulatory changes. As of now, investors can simply go with the earnings reports from banks, which came in assuring, and be bullish on financial ETFs like iShares U.S. Financial Services ETF (IYG), iShares US Financials ETF (IYF), PowerShares KBW Bank ETF (KBWB), XLF and Vanguard Financials ETFVFH (see all Financial ETFs here).

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