Reflation Trade Grips S&P 500 as Banks Hold Up in Bond Rout

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You know the market has come full circle from the credit crisis when financial stocks are what investors are buying for protection.

It’s happening in the Standard & Poor’s 500 Index, where banks and insurers have rallied for five of the last six weeks as drugmakers and household product manufacturers were left behind. Dividend-paying companies such as utilities and property owners, normally considered havens in times of turbulence, have suffered some of the worst losses in years.

The rotation is one of several gripping markets after the prospect of higher inflation and interest rates spurred a selloff on bonds and halted the dollar’s biggest advance in at least 10 years. It’s good news for mutual funds, who had one of their worst years in a decade partly due to embracing banks and avoiding utilities.

“You’re in the midst of a reflation trade,” said Brent Schutte, senior investment strategist at BMO Global Asset Management in Chicago. The firm manages about $240 billion. “People are beginning to think that global growth may improve toward the end of the year, or at least the deflationary forces that are artificially driving things down are now ebbing.”

The shift reflects a growing expectation that central bank stimulus will put to rest the threat of deflation that haunted Europe and Japan since at least 2009. While strengthening global growth is taking the shine off American equities as a whole, the prospect of higher interest rates and a weaker dollar is making banks and multinationals more appealing.

‘Missing Component’

The S&P 500 slipped 0.5 percent at 4 p.m. in New York.

With profit pressure poised to ease as borrowing costs rise, financial stocks in the S&P 500 have extended a rally that began in January to 7.4 percent. Over the same stretch, shares of power producers have declined 9 percent -- the biggest gap in three years.

“There is more inflation being built into the steeper yield, and a steeper yield curve has been a missing component of the financial sector backdrop for years,” Joe Quinlan, New York-based chief market strategist at U.S. Trust, which oversees about $391 billion, said by phone. “The U.S. economy saved the rest of the world in the second half of last year and now the rest of the world will return the favor to the U.S.”

Low interest rates crimped banks’ profitability last year, with net interest margin, the difference between what a firm pays in deposits and charges for loans, reaching a record-low of 3.1 percent, according to St. Louis Fed data.

Financial Rally

Financial shares have beaten utilities every month since January as yields on 10-year Treasury notes climbed to as high as 2.24 percent from a low of 1.64 percent. JPMorgan Chase & Co. has jumped 13 percent in the past three months, reaching a 15-year high, while Goldman Sachs Group Inc. is up 9.3 percent.

As rising bond yields cut the allure of dividends, an S&P index of real estate investment trusts has lost 9.2 percent from its 2015 peak.

Likewise, with the dollar falling almost every week since a 12-year high in March amid economic data that missed economists’ forecasts by the most in six years, the largest American companies have reasserted themselves in the equity market.

The 100 biggest companies in the S&P 500 advanced 1.6 percent in April, compared with a 2.6 percent loss in the Russell 2000 Index of small-caps. A month earlier, megacaps trailed by about the same magnitude, making the reversal the biggest since 2002.

Market Share

While the rotation among sectors is swift, it has done little to help the broader market break out of its trading range with the Federal Reserve standing by to raise interest rates. The S&P 500, after surging more than 200 percent since 2009, is up 2.8 percent this year, trailing almost all other developed markets tracked by Bloomberg.

America’s market share in global equities is sinking at the fastest rate since the 2008-2009 financial crisis. At $24.6 trillion, the U.S. accounts for 35 percent of the world’s stock capitalization, down from 38 percent at the start of 2015.

“We’ve come pretty far, pretty fast for the U.S. market and it only makes sense to take a look abroad,” said Brad McMillan, chief investment officer of Waltham, Massachusetts-based Commonwealth Financial Network, which oversees $97 billion. “The market is digesting slower U.S. growth and for the Fed to start raising rates. Part of the response to that is you want to go with a little bit of defensive strategy and certainly megacaps enable you do that.”

Taper Tantrum

Buying financials and selling utilities proved similarly profitable during the 2013 runup in bond yields known as taper tantrum. Over the months when 10-year Treasury yields climbed from 1.63 percent in May to 2.99 percent in September, banks jumped 6 percent, while utilities tumbled 11 percent.

A lasting outperformance in banks may bode well for mutual funds, who according to Goldman Sachs’ February survey have favored financials over utilities in the past 12 months. That strategy backfired last year, when power producers posted the best return in the S&P 500, surging 24 percent and almost doubling the gain in lenders.

“We’re in the early days of a likely directional change in U.S. monetary policy,” said Michael Cuggino, who helps manage about $5 billion at Permanent Portfolio Family of Funds Inc. in San Francisco. “Investors are game-playing the equity market due to the expected rise in interest rates.”

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