Picking Sectors to Address Market Risks and Opportunities
Many ETF investors have been getting it right with their moves in sectors this year. Sector ETF trades show continued net flows into energy and defensive sectors such as health care and consumer staples and avoidance of financials.
We believe the SPDR Sector Picks of energy and health care remain attractive relative to other sectors.
For those investors looking to take advantage of recent share price falls, US industrials represents an opportunity.
So far this year, two sectors stand out in terms of flow trends. Energy has gathered significant net new assets week by week, much greater as a proportion of the sector’s market capitalisation than any other sector. Financials (including heavily traded bank ETFs), by contrast, saw strong net inflows for the first six weeks of the year then a rapid turnaround and significant outflows since. Both of these trends have been driven by the strong influence of macroeconomic factors on today’s equity market.
Energy investors have been keen to take advantage of higher oil and gas prices and companies that can actually benefit from a high inflation environment. Investors in the financials sector, while initially drawn to expectations of rising interest rates, have more recently become aware of the impact of flat bond yield curves.
Directionally, ETF investors have gotten this right. Whereas MSCI World Energy has returned more than 38% year to date, 51% ahead of the broader MSCI World Index, MSCI World Financials has fallen by 13%, having reached a peak price for the year so far in the second week of February.
Investors have also moved into defensive sectors, principally health care (home to equipment and service providers as well as pharmaceutical manufacturers) and, more recently, consumer staples (beverages, food and household product producers). This risk-averse move sees investors embracing the traditional havens offered by non-discretionary products and relatively low volatility of share price performance.
Sector Flows YTD and Past Month (in USD Millions)
Barbelling energy and health care
One of our sector strategies proposed for 2022 was a barbell strategy to fit a high inflation environment but with consideration for volatility. Our suggestion focused on energy. Given the integral nature of crude oil prices to CPI figures and the high correlation between crude oil prices and the performance of oil and gas companies, energy is easily recognised as the sector with the highest sensitivity to inflation.
In order to reduce the day-to-day volatility, we suggested holding it with a sector offering divergent characteristics – in this case health care, which scores highly on stability of earnings growth and other quality measures (unlike energy) and has lower value exposure and market beta. Our analysis shows that adding these two sectors to an equity portfolio could increase returns in a high inflation scenario with a reduction in risk.
We still find this to be an effective combination.
The war in Ukraine, and the resulting sanctions and disruptions to Russian oil and gas delivery, continue to support tight supply, while the reopening of parts of China from harsh COVID lockdowns should drive short-term demand for fossil fuels. Energy has become less correlated to the rest of the equity markets this year, often being the only sector to produce positive returns when all other sectors are down. The disparity of earnings sentiment, with upgrades to energy earnings, but not elsewhere, suggests this situation could continue in the next few months. Energy is not expensive looking back at the last 20 years.
Meanwhile, the Q1 reporting season has gone well for health care, with large pharma in line or exceeding consensus earnings forecasts and guidance being reiterated or raised. Sales of drug treatments and vaccines for COVID have been among the highlights. State Street custody holdings inform us that institutional investors are still underweight to health care companies and have been steadily buying over the past few months. One reason for past cautiousness has been the fear of pricing pressure on prescription drugs in the US but there has been little sign of this danger for some time.
Play the themes of food security, fuel and supply chain with industrials
Another of our SPDR Sector Picks for Q2 is US industrials. So far this quarter the sector has fallen, dragged down by the market sentiment and fears around peaking PMI figures. In spite of an expected economic slowdown, which typically would hurt this sector, we see emerging tailwinds for many parts of the industrials complex and thus it could be a buying opportunity. Among the themes that can be played in this sector are:
Expected increase in defence spending in Europe and elsewhere, featuring orders for under-resourced attack helicopters, airlift capabilities and missile systems
Demand for the machinery necessary in power generation and renewable energy transition projects as countries look to energy security
Elevated crop prices extending the agricultural cycle; the need for food security could boost demand for agricultural machinery
Rising demand for mining machinery in response to high metals and minerals pricing
Likely increase in demand for drilling equipment after years of constrained capital expenditures by oil producers, which would benefit producers and associated transportation in the sector
Need for automation and robots for companies looking to re-shore manufacturing facilities into countries experiencing full employment
Our preference remains US industrials, partly because this sector has high domestic revenues and US industrial activity may suffer less from economic slowdown. Furthermore, any orders emerging from the US’s $1 trillion Infrastructure Bill, set to build roads, bridges, airports, waterways and power infrastructure, would directly benefit companies based in the US.
How to access this theme
Investors looking to play these sector themes can do so with SPDR ETFs. To learn more about these ETFs, and to view full performance histories, please click on the links below to visit their fund pages.
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