Sector ETFs for Rising Rates and an Improving Economy

July 23rd at 10:58am by John Spence

So far in July investors are shoveling cash into U.S. stock ETFs at the fastest pace in several years. Sector ETF purchases show they are adding risk by gravitating to industries that stand to benefit the most from an accelerating economy and rising interest rates.

“Investors are favoring some cyclical sectors that could be rewarded in this market environment,” said David Mazza, head of ETF investment strategy at State Street Global Advisors.

State Street manages the popular ETF lineup of sector SPDRs.

This month, the top-selling ETFs in the family are Financial Select Sector SPDR (NYSEArca: XLF), Consumer Discretionary Select Sector SPDR (NYSEArca: XLY) and Technology Select Sector SPDR (NYSEArca: XLK).

Additionally, the small-cap iShares Russell 2000 (NYSEArca: IWM) has seen hefty inflows this month. Investors tend to favor small-cap stocks when they are adding risk and expect the economy to pick up. [Stock ETF Buying Spree Reflects ‘Great Rotation’]

“Historically, stock performance during early cycles is dominated by financials and consumer discretionary, which are the most credit-sensitive sectors. In addition, lower quality and smaller companies tend to outperform because they are typically more sensitive to changes in the economy,” according to a Richard Bernstein Advisors paper.

XLF, the financial sector fund, has gathered $1.2 billion of inflows so far in July. XLY, the consumer discretionary ETF, has pulled in $984 million, according to IndexUniverse data.

Interest-rate-sensitive sectors such as consumer discretionary and financials have historically outperformed the market in the early phase of the business cycle, according to Fidelity Investments.

“These sectors have performed well partly due to industries within the sectors that typically benefit from increased borrowing, which includes consumer finance in financials and consumer-linked industries such as autos and household durables in consumer discretionary,” Fidelity notes. [Consumer ETFs Outperforming as Spending Closely Linked to Income]

Within the financial sector, SPDR S&P Regional Banking (NYSEArca: KRE) has experienced inflows of more than $300 million this month. The ETF is seen as a play on rising interest rates and a steepening yield curve. [Regional Bank ETFs in Focus on Higher Rates]

Full disclosure: Tom Lydon’s clients own IWM.

The opinions and forecasts expressed herein are solely those of John Spence, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.

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