It might seem counter-intuitive, but consumer discretionary stocks and the corresponding exchange traded funds might respond more positively to higher interest rates than some investors are giving the group credit for.
The thesis is the Federal Reserve will not raise interest rates until it is entirely confident the U.S. economy can withstand higher borrowing costs. Said another way, the Fed boosting rates could be seen as a sign the U.S. economy is in good shape and that could spark gains for ETFs such as the iShares US Consumer Services ETF (NYSEArca: IYC), Vanguard Consumer Discretionary ETF (NYSEArca: VCR) and the Consumer Discretionary Select Sector SPDR (NYSEArca: XLY).
XLY, the largest consumer discretionary ETF, is the leading performer among the nine sector SPDR ETFs this year.
Retailers make up a large portion of the underlying holdings. E-commerce and greater mobile commerce usage has also been a big game changer in the industry, especially with more consumers using online sources like Amazon (NasdaqGS: AMZN), which XLY holds.
With the U.S. dollar strengthening, currency risk is also a concern for many investors. However, foreign currencies and global consumer spending do not have a major effect on U.S. consumer discretionary sector, according to Morningstar. [Discretionary ETFs for a Growing Economy]
VCR includes a more diversified take on the sector with 385 component holdings and comes with a cheap 0.12% expense ratio.
FDIS, the more recent entrant to the space, also charges a cheap 0.12% expense ratio, but it is smaller than its competitors and is more thinly traded. Potential investors should utilize limit orders to better control trades. XLY’s annual expense ratio was recently lowered to 0.14%.
Higher interest could imply that consumers are more willing to spend Dan Dolan, director of wealth management services at State Street Global Advisors’ Sector SPDR Trust, said in an interview with Investor’s Business Daily.
Still, there are some catalysts for discretionary ETFs, such as XLY, including the rising minimum wage. Meanwhile, a growing segment of America is calling for higher minimum wages across the government after years of stalled efforts. The national minimum wage has been set at $7.25 per hour since 2009, and changes would require the support of the Republican-controlled Congress.
A number of research has pointed to improved economic conditions from higher wages. For instance, in a 2011 study by the Chicago Federal Reserve, the author found that for ever dollar increase in minimum wage, a worker’s household added $2,800 in new consumer spending over the following year.
Vanguard Consumer Discretionary ETF
Tom Lydon’s clients own shares of XLY.