Insights

SPDR® SSGA US Sector Rotation ETF (XLSR) – Q2 2022 Commentary

During the second quarter of 2022, XLSR finished lower, but outperformed the S&P 500 index. The fund finished the quarter with overweight positions in Materials, Utilities, Energy and Industrials.



Performance

Targeted allocations to Energy and Utilities supported relative performance and offset negative impacts from Financials and Technology. The Energy overweight was held throughout the quarter and, while the sector struggled in June on increased recession and demand destruction fears, it outperformed in April and May, helped by strong fundamentals in the commodity complex. Utilities benefited from the risk-off sentiment and while they finished lower, outperformed the broad S&P 500 index. While we reduced our allocation to Technology back to neutral in April, the overweight to begin the quarter detracted from performance as the sector has struggled with rising rates.

Fund Performance

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Portfolio Allocations

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Portfolio Positioning and Outlook

Headwinds to global growth have intensified while sources of resilience have softened. SSGA’s 2022 US growth forecast has moved from a little above consensus in March (4.0%) to a little below now (2.3%).1 While global shocks have continued to compound and weigh on our outlook, the downgrade reflects a much faster monetary tightening pace that shifts the economy from the prior path of a gradual deceleration to a more abrupt downshift. Anxiety about global growth will persist in the near term. With inflation accelerating, the US Federal Reserve (Fed) and other central banks have confirmed their dedication to curbing inflation at all costs.2 Inflation is broad based and proving more sticky than anticipated, geopolitical risks from the war in Ukraine have seemingly increased, and we are becoming less convinced the Fed can administer a “soft landing” with the current trajectory of both interest rates and growth. Risks remain skewed to the downside and we will monitor developments closely.

In our view, the risks to equity markets still outweigh the potential for a meaningful rebound. In addition to the challenging risk environment mentioned above, our equity modeling also has deteriorated steadily since late last year. Valuations have improved, but high inflation and slow manufacturing data have turned cycle indicators in a less productive direction. Price momentum has weakened, but the most dramatic area of weakness has been around earnings and sales expectations. With that as the backdrop, we prefer a relatively defensive stance as it pertains to our overall equity market exposure.

From a sector perspective, our allocations are barbelled between high beta sectors such as Energy and Materials and the low beta Utilities sector. Both Energy and Materials experienced some significant retracements in June as markets began to take the risk of recession more seriously. And while the hit to short-term momentum is clear, these sectors continue to look attractive based on a variety of valuation and macroeconomic indicators, including EBITDA multiples and an economic cycle characterized by slowing growth and high inflation.3 Should that slow growth turn further south, these sectors could be at risk. But we’ve not yet seen the data cross that threshold to downsize our allocations. Utilities are typically the lowest beta equity sector and our allocation provides some ballast to the otherwise more cyclical exposures in which we have invested. In their own right, Utilities fare well in our equity research based on relatively stable earnings and sales expectations, above average momentum, and improved sentiment from a fund flow perspective.

Market Regime Forecasts

The Market Regime Indicator (MRI) employs a quantitative framework and forward-looking market indicators, including equity- and currency-implied volatility, as well as credit spreads, to identify the current market risk environment. Tracking risk appetite shifts in the market cycle helps frame tactical asset allocation and volatility targets.

A Look at the MRI

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