Many investors have used sector ETFs for positioning during the COVID-19 crisis. As investment vehicles, sector investments via ETFs provide diversification and help to mitigate the risk associated with investing in just one company. Sectors also provide the ability to target more defensive parts of the economy that could benefit most from recovery or that have been overly marked down given long-term prospects.
Many investors have recognised the potential benefits of sector selection and may have profited from the much higher dispersion of sector returns over recent months, as seen in the chart below. During this period, flows into sector ETFs reached near-record levels. The highest inflows have consistently been into Technology and Health Care, which have shown strong earnings sentiment. Financials has been unpopular as various QE measures are likely to hit margins for an extended period of time and there has been heavy two-way trading in Energy.
Return dispersion has dampened but there is still a significant difference between sector returns year to date: MSCI World Information Technology NTR has returned 5% while Energy is down 34%.
Source: State Street Global Advisors, Bloomberg Finance, L.P., as of April 30, 2020. Past performance is not an indication of future returns.
As noted in our Q2 SPDR Sector Compass, we see three possible paths to economic recovery, dependent on control of the virus spread, public action and subsequent reopening of economies. Initially, most investors expected a relatively quick containment of the virus, followed by a V-shaped economic recovery. It was assumed the public health response would be successful within months, and new measures, such as antibody testing, would allow a quick return to physical work and consumers resuming their usual behavior.
In this ’Quick Recovery’ scenario, as illustrated below, we prioritised relative earnings stability. Top of our Sector Picks for Q2 was Health Care for its sheer defensiveness, followed by Technology and Communication Services, which we believed would see a relatively lower fall in demand for their products and services.
The above diagram is for illustrative purposes only.
While infection rates and death rates have hopefully peaked and economies are reopening, the trajectory for activity levels is more uncertain than assumed two months ago. Worryingly, no one can rule out a reoccurrence of virus spread and consequential re-imposition of physical distancing measures. Economic damage looks greater than initially feared and earnings forecasts have still not reflected these top-down predictions. This ’Delayed Recovery’ scenario suffers bumps in the path to economic recovery.
All three Sector Picks still present opportunity in this more negative scenario. These sectors play to business and social themes that could become norms post-COVID 19, such as a greater propensity for working at home, more online shopping from social media platforms, and a ramp-up in health testing and vaccine research. The opportunities in inherent in these growth segments should help offset earnings weakness in other parts of tech, communication services and health care businesses.
Whereas more cyclically sensitive sectors, such as Industrials and Consumer Discretionary, would be attractive if recovery were closer to a V-shape, they are now less appealing. Meanwhile, traditionally defensive sectors could provide relative downside protection, for example Consumer Staples, with its broad product range of food, beverages, tobacco and household goods, and Utilities. The latter should shine during a recessionary period, offering relatively low volatility and low correlation to other equities; however, so far it has been largely ignored.
Given the response to public health measures and policy stimulus, it is extremely unlikely now that we face the worst case scenario, which we named ‘Persistent Issues’. Were there a threat of escalation of the pandemic and a long recessionary period, we would assume more investor demand for Utilities (given its low correlation with the rest of the market) and Health Care (higher demand for its products and services).
All sectors rose globally in May on excitement of economies reopening and renewed risk-on appetite. The equity rally broadened out with a rotation towards value at the expense of growth stocks, with cyclicals outperforming defensives, and high short-interest stocks outperforming crowded and low-short-interest stocks. This is not a surprise given the performance gap that had opened up, but it could be short-lived as it did not come with any better economic news.
We can see from relative flow directions and sentiment indicators that investors remain cautious. The risks are still there and we could see many economic and corporate disappointments on the path to recovery. It could pay to be more defensive or in sectors that are still suffering least from COVID-19 related disruption. We reiterate the SPDR Sector Picks.
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