Sector Rotation in Anticipation of Rate Cuts

12 de ago.

Markets have rebounded sharply after last week's fear-driven decline. Despite this, rate cuts are still anticipated in the upcoming FOMC meetings. Changes in monetary policy often benefit some sectors over others, providing investors a chance to adjust their portfolio allocations accordingly.

This paper delves into a comparative analysis of sectors around monetary policy pivots to highlight how a spread between S&P Financials Select Sector and S&P Utilities Select Sector stands to benefit in the coming months. It also describes a hypothetical trade setup using CME E-Mini S&P Select Sector futures which can be used to express the view in a margin-efficient manner.


RATE CUTS WILL HURT FINANCIAL FIRMS

Financial firms benefit significantly from higher rates, as these drive net interest margin (NIM) expansion, boosting their bottom line. However, when rates start to decrease, this positive impact reverses.

The Financials Select Sector ETF (XLF) is comprised of 25% banks, 31% financial services firms, and 16.6% insurance firms. All these firms have benefited from higher rates, albeit the strongest impact may be limited to banks and insurance firms whose overall bottom line is significantly impacted by expanding NIM.



In the last three monetary policy pivots, XLF has declined by an average of 5.6% over the following six months. Conversely, at the start of rate hikes, the ETF has typically risen by an average of 3.7% in the subsequent six months. While the most recent pivot in 2019 saw an increase in XLF, the overall average trend suggests a decline.

The trend is visible even when examining the relative performance of XLF and SPX. Following rate cuts, the spread declined by an average of 2.8% while during rate increases, it declined by just 1.1%.



There is another headwind facing the XLF ETF, particularly banks – rising credit delinquencies. Credit card delinquencies are especially concerning as they stood at the highest level in 13 years as of Q1 2024. Overall delinquencies are also rising and near the highest level since 2021.



Updated data from the New York Fed has shown that conditions remained stressed in Q2 with total delinquencies at 3.2%. Particularly concerning were severe (>90 days delinquent) credit card delinquencies at a staggering 10.93%. Consumers are increasingly relying on unsustainable credit card debt to cover expenses. As delinquencies remain elevated, issuing banks must increase loan loss provisions which impacts earnings directly.

Source: New York Fed

As credit card usage becomes unsustainable, another class of companies in XLF – payment processors - will also be hurt. The largest payment processors (Visa, Mastercard, and Amex) represent nearly 15% of the XLF index.


RATE CUTS WILL BENEFIT UTILITY FIRMS

Unlike financial firms, utility companies have struggled in a high-rate environment. As their huge capital expenditure is often fueled by debt, higher rates result in narrower profits.

As rates decline, debt payments decrease, leading to expanded profit margins for utility firms. Historically, the ETF has shown a significant average increase after rate hikes and a smaller increase after rate cuts. This behavior might be due to investors anticipating a weakening economy following rate cuts, which would favor utility firms. However, the index tends to correct later once rates remain elevated for some time.



The impact is close to even when comparing the relative performance against the broader S&P 500 with both periods resulting in a ~6% increase in the spread.



Utility firms are also likely to outperform in case of a US recession. Although some of the concerning economic data has normalized over the past week, the risk of a recession in the US persists. As utility firms provide essential services, their cash flows are relatively stable even during recessions. While consumers may cut down on discretionary spending, spending on essential services remains unaffected.

Mint Finance previously covered these factors in a separate paper.

HYPOTHETICAL TRADE SETUP

A pivot in Fed Policy is expected in the upcoming FOMC meetings with the CME FedWatch tool signaling 100 basis points of rate cuts in 2024 itself. Rate cuts will impact different sectors differently. While utility firms stand to benefit from lower rates, financial firms may see lower profits.

Source: CME FedWatch

The spread between CME E-Mini Utilities Select Sector Futures (XAU) and CME E-Mini Financial Select Sector Futures (XAF) has been rising since March as it has favored XAU. The spread responded strongly to a shift in rate cut sentiment as well as the recession signal at the start of the month.



The recent correction over the past week offers an improved entry point into the spread.

A hypothetical trade setup using XAU futures expiring in September (XAUU2024) and XAF futures expiring in September (XAFU2024) is described below. CME offers margin offset totaling 60% for this spread reducing the capital requirement to USD 3,740.






MARKET DATA

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