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Weathering The Trade War Through Effective Sector Allocation

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Includes: AAPL, MA, SPY, V, XLB, XLC, XLE, XLF, XLI, XLK, XLP, XLRE, XLU, XLV, XLY
by: Sankalp Soni
Summary

Amid rising trade tensions, it is becoming increasingly important to allocate prudently among the various equity sectors in order to find the right balance between risk and reward.

Out of all defensive sectors, the Utilities sector offers the best protection from trade tariffs and a slowing global economy.

While the Tech sector holds the highest global revenue exposure, it still offers one of the highest profit margins, making it an appealing portfolio allocation choice.

Since January 2018, trade tensions have been on the rise, with the US government embroiled in feuds with several of its trading partners, particularly China. This has hurt both US and global economic conditions, and has led to increased volatility in the stock market. Companies with high international revenue exposure and/or input costs affected by tariffs have witnessed the most bearish pressure on their stocks. Given that the trade tensions are not going away any time soon, it has become essential for investors/ portfolio managers to allocate effectively among the various equity sectors, in a manner that produces investment returns, while also minimizing volatility risk. While during times of such economic uncertainty investors tend to flee to the defensive sectors, the Utilities sector seems to offer better risk-reward potential and protection from the trade tensions, compared to the other defense plays.

In order to determine the ideal allocation among the various sectors amid ongoing trade concerns, a Markowitz Efficient Frontier has been generated using Excel Solver, with each plot on the frontier representing different efficient portfolios. Sector ETFs issued by State Street Global Advisors have been used as proxies to represent equity sector performances. The monthly performances of the sector ETFs since January 2018 (beginning of trade tensions) have been used to determine the Expected Returns and Standard Deviations (volatility risk) going forward.

For simplicity, specific plots along the frontier have been numbered, a reference to which can be found in the table below, detailing the portfolio expected return, portfolio standard deviation, Sharpe ratio, and the recommended weighting across the different sector ETFs for each portfolio.

Portfolio 6 offers the highest monthly return, though it also poses the highest volatility risk with a standard deviation of 19.26%, given that it suggests a 100% allocation to the Technology Select Sector SPDR ETF (XLK). However, ideally we would want to diversify towards other sectors to lower our portfolio volatility. Portfolio 1 represents the Minimum Variance Portfolio (NYSE:MPV), which offers a monthly-expected return of 11.92%, with a standard deviation of 9.01%. Hence, for less than half the volatility risk, the portfolio offers a monthly return only about 4% less than portfolio 6 (highest return potential). Therefore, investors seeking the most efficient portfolio with the lowest volatility risk would not be foregoing too much return relative to the significantly lower risk exposure offered by the MPV. This portfolio would suggest an 82.90% allocation to the Utilities Select Sector SPDR ETF (XLU), 10.21% allocation to Communication Services Select Sector SPDR ETF (XLC), 3.44% allocation to the Health Care SPDR ETF (XLV) and 3.45% allocation to XLK.

However, the portfolio offering the best risk-reward potential is Portfolio 3 (highlighted in red), as it offers the highest Sharpe ratio at 1.49. This efficient portfolio choice would also recommend the largest weighting towards the Utilities sector (XLU). More specifically, the portfolio implies an 84.79% weighting to XLU, and a 15.21% allocation to the Tech sector (XLK). For nearly the same risk (S.D. of 9.10%), portfolio 3 offers a notably higher expected return (13.57%) compared to the MPV, and thus makes it a more attractive portfolio allocation choice.

The table of portfolio weightings demonstrates that the two sector ETFs that are most recommendable to obtain an efficient portfolio, are Utilities (XLU) and Tech (XLK).

In a recent research piece of mine, we had found that amid the ongoing global trade tensions, the Utilities sector (XLU) posed the lowest tail risk/ Value at Risk (VaR), with a Historical VaR of -3.90%, and Modified VaR of -4.08%. On the other hand, the Tech sector (XLK) had one of the highest tail risks, with a Historical VaR of -8.43% and a Modified VaR of -9.28%. However, out of the sectors that posed the highest tail risks, XLK also offered the best risk-reward potential, with a Rachev ratio of 1.25 (a ratio above 1 implies more upside potential than downside risk).

The Utilities sector has been one of the market-leaders lately, with XLU up about 14.70% YTD. Defensive sectors like Utilities are generally attractive during times of slowing economic growth. Though out of all sectors, Utilities has the lowest global revenue exposure (3%), making it a more appealing defense play than Health Care (38%) and Consumer Staples (45%) amid deteriorating global economic conditions and ongoing trade issues. Moreover, based on Q1 2019 earnings results, the Utilities sector also offers the best net profit margin (13.2%) compared to the other defensive sectors, Health Care (10.4%) and Consumer Staples (6.2%). Apart from revenue exposure/ earnings growth, another major catalyst for the bullish run in Utilities is that fact that amid a slowing economy and an increasingly dovish Fed, Treasury yields have been plummeting; with the 10yr yield falling to around 2%. The Utilities sector is not only appealing due to its defensive characteristics, but also because it offers attractive dividend yields. XLU currently offers a dividend yield of 3.42% (at time of writing), which is notably higher than the yields offered by Treasury securities. Hence, investors in search for yield are also pushing the Utilities sector higher amid the dovish Fed.

The Tech sector has the highest global revenue exposure out of all sectors (57%), and therefore makes it one of the most sensitive to ongoing trade wars and a slowing global economy. Q1 2019 Tech earnings declined by 6.3%, and are expected to continue declining until at least Q4 2019. However, the sector still offers one of the best profit margins (21%) even amid a slowing economy, emboldening the case for allocating a certain portion of a portfolio to the Tech sector. Furthermore, within tech, certain industries are more exposed to the trade war than others (particularly Semiconductors), which end up dragging the overall Tech sector lower. While hardware companies (e.g. Apple (AAPL)) that rely heavily on selling physical goods to generate revenue are highly exposed to the trade war in terms of rising input costs and declining sales, certain tech services companies offer better protection from trade tensions given that tariffs do not affect their input costs. While they may not offer complete protection from a slowing global economy of course, they still offer one of the highest revenue/ earnings growth rates and strongest balance sheets, such as Visa (V) and MasterCard (MA). Hence, while this research focuses on broader sector allocations, investors should certainly look into individual stocks within the Tech sector that offer better returns than others amid rising trade tensions.

Valuations

Given that our portfolios on the efficient frontier mainly suggest allocations to the Utilities (XLU) and Tech (XLK) sectors, we must also take into consideration their valuations relative to the S&P 500 SPDR ETF (SPY).

Data Source: Morningstar

Both the Utilities and Tech sector ETFs are more expensive than the S&P 500 benchmark ETF in terms of almost every valuation metric. Hence investors that seek to allocate funds towards these two funds in their portfolios should take valuation risk into consideration; if future earnings do not meet expectations/ deteriorate, than the ETFs could be forced to slump downwards towards more appropriate valuations. Though out of the two sector ETFs, Utilities (XLU) is cheaper than Tech (XLK), hence further supporting the concept of allocating a majority of one's portfolio to XLU, and a smaller portion to XLK. Moreover, XLU also pays a higher dividend yield (3.42%) compared to XLK (1.63%) and SPY (2.17%), making it more appealing to hold exposure to amid declining Treasury yields.

Bottom Line

Rising trade tensions have made it ever more important for investors and portfolio managers to allocate prudently across equity sectors to minimize risks while trying to generate investment returns. From our Markowitz Efficient Frontier, we found that the portfolio with the best risk-reward attribute suggests an 84.79% allocation to the Utilities sector (XLU) and a 15.21% allocation to the Tech sector (XLK), which would offer a Sharpe ratio of 1.49. This would effectively combine the sector ETF with the least global revenue exposure with the sector offering the highest net profit margins.

The Utilities sector also offers an attractive dividend yield (3.42%), which makes it a great source of income as the Fed turns increasingly dovish and causes Treasury yields to drop. With regards to the Tech sector, not all companies are affected by the trade war equally. Hence while this research explores ideal portfolio allocation strategies on a broader sector level, investors should explore individual tech services companies that offer high revenue/profit growth rates while being relatively unaffected by trade tariffs.

Overall, a portfolio adeptly combining the Utilities and Tech sectors, with the right balance, should offer the best efficiency/ risk-reward trade-off.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.