Investors should consider sector-specific ETFs to focus on targeted segments of the market, especially as U.S. markets head in to the late business cycle.
On the recent webcast, How Sectors Can Help with a Changing Market, Matthew Bartolini, Head of SPDR Americas Research, State Street Global Advisors; Robert Forsyth, III, Head of SPDR Americas Client Enablement Group, State Street Global Advisors; and Colin Ireland, Head of SPDR Americas Institutional & Home Office Strategy, State Street Global Advisors, explored sector views for the quarter.
In 2019, momentum in cyclical sectors quickly recovered from both a performance and flows perspective as investors looked to areas like communication services, technology and financials over recent weeks.
A flattening yield curve previously fueled outflows in the financial sector, but a stable yield curve and better-than-expected earnings growth helped reignite investment demand for the sector over April. Financials in particular appear attractive on an absolute and relative basis to the S&P 500.
On a valuation standpoint, other areas like materials, industrials and energy appear attractive relative to the S&P 500. On the other hand, the consumer discretionary segment’s valuations appear stretched, along with healthcare and utilities.
Defensive sectors expected to lead growth
Looking ahead, while defensive sectors are expected to lead growth for now, analysts expect higher growth in cyclical sectors for 2019.
Investors who are interested in taking a sector approach to investing in the markets have a number of sector-specific ETF options to choose from, including:
- Communication Services Select Sector SPDR Fund (NYSEArca: XLC)
- Consumer Discretionary Select Sector SPDR ETF (NYSEArca: XLY)
- Consumer Staples Select Sector SPDR Fund (NYSEArca: XLP)
- Energy Select Sector SPDR (NYSEArca: XLE)
- Financial Select Sector SPDR Fund (NYSEArca: XLF)
- Health Care Select Sector SPDR ETF (NYSEArca: XLV)
- Industrial Select Sector SPDR (NYSEArca: XLI)
- Materials Select Sector SPDR (NYSEArca: XLB)
- Real Estate Select Sector SPDR Fund (NYSEArca: XLRE)
- Technology Select Sector SPDR ETF (NYSEArca: XLK)
- Utilities Select Sector SPDR (NYSEArca: XLU)
The State Street Global Advisors’ strategists argued that investors should consider sector-specific exposures to better diversify their investment portfolios. Correlations between sectors tend to vary markedly, which may provide another source of diversification to an equity portfolio. Additionally, the various sectors exhibit wide dispersions of returns, potentially opening opportunities to add value by overweighting potential winners and underweighting losing segments.
When considering a sector pick, investors should still do their due diligence. For example, one should survey macro economic environment and analyze business cycles, position according to changes in certain macroeconomic variables, identify secular industry trends, harness long-term growth rends within a particular segment, evaluate sector fundamentals, position towards areas that show attractive valuations and overweight or underweight sectors based on recent performance.
As an overarching theme, investors should consider how to position in the slowdown or late stages of the normal business cycle. The slowdown period is characterized by capacity utilization peaks, positive output gaps, positive but decelerating growth and more restrictive monetary policy. In this type of environment, investors may find that consumer staples, healthcare and industrials tend to outperform, whereas materials, consumer discretionary and real estate segments tend to underpeform.
State Street Global Advisros argued that investors should consider overweighting the top three sectors that trade at cheap valuations with improving earnings. Investors, though, should keep in mind that a portfolio with equal allocations to the top three sectors based on valuations or momentum scores has historically exhibited active risk exposures to value and momentum factors, which may cause a significant portfolio tilt if one already includes these factor allocations.
State Street Global Advisors also highlighted thematic plays that could help investors harness macro ternds or shifts in economic fundamentals. For example, the SPDR S&P Oil & Gas Exploration & Production ETF (NYSEArca: XOP) and SPDR Oil & Gas Equipment & Services ETF (NYSEArca: XES) show beta sensitivity to changes in the Brent Crude Oil prices. Meanwhile, something like the SPDR S&P Regional Banking ETF (NYSEArca: KRE) and SPDR S&P Bank ETF (NYSEArca: KBE) exhibit beta sensitivity to the U.S. 10-year yield.
Thematic plays can also capture long-term secular trends that emerge as economies evolve. For instance, the the SPDR Kensho Clean Power ETF (NYSEArca: XKCP) can help capture the increase in investments in renewable energy while the SPDR S&P Telecom ETF (NYSEArca: XTL) provides exposures to opportunities and developments in 5G Networks.
Financial advisors who are interested in learning more about sector strategies can watch the webcast here on demand.