The outlook for sector ETFs (IGM, IYW, MTK, XLK, IXN, VGT, XLY, VCR)

In last month’s asset class review, writes J.D. Steinhilber, founder of ETF newsletter and investment management firm Agile Investing, we discussed how several market trends seemed to be pointing to a slowdown in the U.S. economy:

1. a flattening yield curve,
2. widening credit spreads (i.e. the yield premium of corporate bonds relative to Treasuries),
3. then-weak commodity prices, and
4. leadership by the classic late-cycle, defensive sectors (i.e.  Utilities, Consumer Staples, and Healthcare).

Indeed, the prevailing sector rotation in both March and April was the abandonment of cyclical sectors in favor of less economically sensitive sectors.

We were hesitant to draw any firm conclusions from these sector dynamics during the March/April stock market correction because we felt that concerns about an imminent, pronounced economic downturn were premature, given that the key underpinnings of the economy – extremely benign long-term interest rates, record corporate profits and a sizzling housing market – appeared very much intact.   In last month’s report, we noted that sector rotations can occur rapidly and money could quickly shift back into economically sensitive areas of the market if economic concerns subsided, which is in fact what happened in May.

The two strongest sectors last month were technology (+7.7%) and consumer discretionary (+5.8%) – both of which are mid-cycle growth sectors.   [Technology ETFs: IGM, IYW, MTK, XLK, IXN, VGT; Consumer discretionary ETFs: XLY, VCR.]

In the same way that we were not prepared to draw any firm conclusions from the sector patterns in March and April, we are not going to read too much into the shift in leadership seen in May.  It is impossible to know at this juncture whether the recent renewed strength in cyclical sectors is a rebound from an oversold condition or the start of a new trend supported by a healthy economy.   

The uncertainties about the economy and the interest rate backdrop are just too great in our view to have a great deal of conviction on this point.  We would prefer to maintain a cautious posture with respect to sector positioning in our portfolios until further evidence unfolds about whether the U.S. economy will experience a hard or soft “landing.