- While technology and financial stocks offer much different characteristics, both sectors could perform well in 2018
- Rising interest rates can be helpful to financial companies without harming technology companies
- Different aspects of tax reform could prove beneficial to both sectors
In 2017, the bull market for equities across the U.S. market and around the globe has continued with few interruptions. However, the leadership of the rally has changed from 2016, when large-cap value stocks outperformed large-cap growth stocks by 8.95%. During 2017, large cap-growth stocks – and in particular, the technology sector – have led the way in the United States, outperforming large-cap value stocks by 17.25% through October 31.
Where is the tech trend headed? Technology’s strength seems durable, but looking into 2018, with the prospect of a sustained increase in interest rates, the financials sector also looks attractive. Is it possible for both sectors to outperform concurrently?
How technology and financials could rise together
For many investors, choosing to favor growth or value styles may seem like a binary one. The question of whether to favor the financials or technology sector may seem binary as well, because financials is the largest sector in the large-cap value index and technology is the largest sector in the large-cap growth index. However, a scenario is developing in which both sectors could outperform the broader market.
There are three primary reasons why we believe both sectors can do well moving forward: higher interest rates, tax legislation, and stronger earnings growth.
Higher interest rates can be helpful to financials and harmless to tech
For much of the past twelve months, financials have come to represent the “Trump Trade” — that is, a key investment opportunity for people who believed that the Trump Administration would be able to stimulate the economy, enact deregulation, and cut taxes. While the Trump Administration has been delayed in delivering many of the agenda items that investors had hoped to see in 2017, the U.S. economy has nonetheless continued to grow and the Fed has remained on a more hawkish trajectory.
This last factor, Fed policy, is particularly favorable for financials. This sector has historically performed well during rising rates cycles and has the highest correlation of price performance to interest rates. Also, on a fundamental level, if a growing economy supports a steeper yield curve with a significant difference between long and short yields, banks stand to benefit from stronger earnings due to higher net interest margin and increased lending revenues.
While higher interest rates might not have the same salutary effect on other sectors, they should not be a hindrance for the technology sector. That’s because many tech companies have relatively low debt on their balance sheets; the tech sector has the lowest interest expense burden of any sector in the S&P 500.
Tax reform could help both sectors
The second reason both sectors can perform well in 2018 is that both sectors will likely benefit from tax legislation. Financials would benefit if lower taxes lead to stronger economic growth and loan growth, and the potential for inflation to increase the difference between short and long yields. An economic backdrop with such characteristics has historically benefited financials, especially banks. Technology companies would benefit from a repatriation tax holiday, such as the one enacted by the George W. Bush Administration in 2004. Technology is the sector with the most sales and profits derived from outside of the United States. As a result, technology is the sector with the largest amount of cash held overseas and would be one of the biggest beneficiaries of repatriation.
Earnings may continue rising
As we look to the next leg of this bull market, the most important factor is the continued strength in earnings growth. Earnings have increased through three quarters in 2017 and this trend appears to have the momentum to continue into 2018. With a strong international economy and continued domestic economic growth, earnings in both the tech and financials sectors are expected to finish 2017 on a high note, and could grow at a double-digit rate in 2018, we believe.
Two potential engines of performance
Traditionally, many investors have viewed the asset allocation decision between value and growth as a binary decision. This may not be the case today as tech and financials both have the potential to outperform going forward. In fact, within the context of this market, investors should consider the benefits of allocating into both sectors.
The Russell 1000 Growth Index is an unmanaged index of those companies in the large-cap Russell 1000 Index chosen for their growth orientation. The Russell 1000 Value Index is an unmanaged index of those companies in the large-cap Russell 1000 Index chosen for their value orientation. You cannot invest directly in an index.