NEW YORK (Reuters) - U.S.-based mutual fund managers worried about the outlook for bank earnings have been trimming financial stocks from their portfolios, although some value-oriented portfolio managers and analysts said they still see attractive opportunities in the sector.

Traders work on the floor of the New York Stock Exchange (NYSE) in New York, U.S., August 31, 2018. REUTERS/Brendan McDermid

The average U.S. based mutual fund reduced its stake in financial companies by nearly 1.1 percentage points in the second quarter to approximately 14 percent, the largest one-quarter decline since at least 2013, according to Goldman Sachs.

The move away from banks, insurance companies, and mortgage lenders came as the financial sector has underperformed the broad S&P 500 benchmark index by more than 5 percent since April.

Many fund managers believe banks have already hit peak earnings. One red flag is that the U.S. Treasury yield curve has been flattening as short-term yields rise in anticipation of U.S. interest rate hikes from the Federal Reserve while long-term yields fall on worries about economic growth and trade tensions. This situation generally squeezes bank profits.

Some investors worry long-term yields might eventually dip below short-term yields. Such a yield curve inversion that can signal a looming recession.

“The flatter the yield curve the harder it is to make money,” said Ian McDonald, co-leader of the financials research team at Janus Henderson Investors, which oversees $370.1 billion in assets under management, adding that “funds are looking around and saying that if we’re going to see weaker growth then we need to get out of financials.”

The spread between the yield of two- and 10-year U.S. Treasuries US2US10=RR is trading around its flattest in 11 years. Rising short-term rates raise a bank's borrowing costs, while falling long-term rates limit how much they can charge for loans.

Yet McDonald said large-cap banks like JPMorgan Chase and Co JPM.N, Bank of America Corp BAC.N, and Citigroup Inc C.N remain attractive even if the sector overall does not. The major banks have been investing in online platforms and mobile apps, making them more appealing to millennials and less dependent on costly branches, he noted.

“The U.S. retail banking industry is moving from the post-crisis phase of risk management to the fintech phase of managing customer experience,” he said.

Ben Kirby, portfolio manager of the $15.4 billion Thornburg Investment Income Builder fund, said his fund has been moving more into European banks such as ING Groep NV INGA.AS, prompted in part by a recent sell-off in shares following the steep decline of the Turkish lira. The Turkish currency has plunged more than 40 percent this year due to increasing tensions with the United States and concerns that the country's central bank is losing its independence under President Tayyip Erdogan.

“The U.S. has been the market darling for the last 10 years, and that’s led to valuations that are a bit more stretched and an economic cycle that is a bit more mature,” Kirby said. “Whereas in Europe it’s earlier in the cycle and growth is accelerating more.”

Overall, companies in the S&P 500 financial sector trade at a trailing price to earnings ratio of 14.5 and are up 2.2 percent for the year to date, according to Thomson Reuters data. The broad S&P 500, by comparison, trades at a trailing P/E of 22.06 and is up nearly 9 percent over the same time.

Investors have retreated from financials as well, with the Financial Sector Select SPDR, an ETF that tracks financial stocks in the S&P 500, losing $1.7 billion in outflows over the last 4 weeks, according to Lipper data.

Though banks have stronger balance sheets than at the start of the financial crisis 10 years ago, “we’re having a hard time finding anything to get excited about in financials,” said Tom Plumb, manager of the $29.7 million Plumb Equity Fund.

Instead of banks, Plumb has his largest positions in credit-card and payment companies Visa Inc V.N and Mastercard Inc MA.N, continue to grow as more retail purchases are made online rather than in physical stores, he said.

“It’s a mistake to get off a big macro secular trend too early,” he said.

Kyle Martin, an analyst at Westwood Holdings Group, a Dallas firm with $21.6 billion in assets under management, said that rising interest rates and the flattening yield curve could point to a recession in 2020, meaning financial stocks are less attractive.

Investment bank Houlihan Lokey Inc HLI.N looks attractive despite the prospect of declining economic growth given its focus on middle-market mergers and acquisitions, which should see above-average deal activity as the threat from technology disruption grows, he said.

“Banks are clearly safer than they were 10 years ago,” he said. “At the same time, they will see a decline in earnings soon and it’s easy for a fund manager to not have those listed on a client statement if we go into another crisis.”