XLB: Pending Chinese Stimulus Will Benefit Materials Companies

Summary

• XLB ETF provides broad exposure to materials companies.
• Recent news that China is preparing to loosen property restrictions could power materials stocks in 2023.
• In 2009 to 2010, during China's last big stimulus program, the XLB outperformed the SPY ETF by 34%.

Nordroden

The Materials Select Sector SPDR ETF (NYSEARCA:XLB) provides broad exposure to materials stocks. Materials look poised to take the market leadership reins from the energy sector, as China appears to be loosening property regulations and getting ready to stimulate its economy. China is the largest consumer of most commodities and any Chinese stimulus program would provide a big boost to materials demand.

Fund Overview

The Materials Select Sector SPDR Fund is a materials sector-focused ETF offered by State Street Global Advisors ("SSGA"). It tracks the Materials Select Sector Index ("Index"), an index that aims to represent the materials sector of the S&P 500 Index. The index provides exposure to companies in the chemical, construction material, containers and packaging, metals and mining, and paper and forest products sub-industries. The XLB ETF has $5.3 billion in assets while charging a 0.1% gross expense ratio.

Portfolio Holdings

Figure 1 shows the XLB ETF's characteristics. The XLB ETF holds 29 companies with average Price-to-Earnings ratio of 13.9x.

Figure 1 - XLB fund characteristics (ssga.com)

Figure 2 shows the fund's sub-industry allocation. The XLB ETF is heavily weighted towards chemicals companies, which account for 67.7% of the fund. Metals & Mining is the second largest weight at 17.0%.

Figure 2 - XLB sub-industry allocation (ssga.com)

Within chemicals, industrial gas companies dominate with Linde plc and Air Products commanding the top and 2nd largest weight in the fund at 17.1% and 7.6% respectively. Altogether, the top 10 stocks account for 63% of the fund (Figure 3).

Figure 3 - XLB top 10 positions (ssga.com)

Returns

Figure 4 shows the XLB's historical returns. The XLB has generated respectable long-term returns with 3/5/10 Yr average annual returns of 10.4%, 7.3%, and 9.8% respectively to December 31, 2022.

Figure 4 - XLB historical returns (morningstar.com)

Note however, the XLB has underperformed the market in the long-run. For the same timeframes, the SPDR S&P 500 ETF Trust (SPY) has returned 7.6%/9.4%/12.5% respectively (Figure 5).

Figure 5 - SPY historical returns (morningstar.com)

Furthermore, the XLB has been more volatile than the market, with 3 and 5 Yr St. Dev. of returns of 24.8% and 21.7% respectively vs. 21.1% and 18.6% for the SPY ETF.

Distribution & Yield

In the past twelve months, the XLB ETF has paid $1.76 / share in distribution, which equates to a trailing 2.2% yield. Seeking Alpha awards the XLB an 'A+' grade for its distribution (Figure 6).

Figure 6 - XLB distributions (Seeking Alpha)

Time For Materials To Outperform Energy?

2022 was a tough year for equity investors, with energy and utilities being the only sectors to generate positive returns. Materials was no exception, as it returned -12.3%; better than the S&P, but still negative.

Looking forward, there are signs that materials may be ready to take the reins of market leadership away from energy. Figure 7 shows the ratio between the XLB and the Energy Select Sector SPDR ETF (XLE). This ratio has returned to multi-year support ~0.85, and is shaping an inverse head and shoulders technical pattern. There is also positive divergence in the weekly PPO indicator.

Figure 7 - XLB vs. XLE (Author created with price chart from stockcharts.com)

Material Stocks Stormed Out Of The Gates In 2023

While perusing dozens of charts as part of my weekly investment process, I was taken aback by the 1-day and 1-week performance of stocks in the materials sector. For example, the VanEck Vectors Gold Miners ETF (GDX) returned 10.1% in the past week and 3.0% on Friday, January 6, 2022. Similarly, the SPDR S&P Metals and Mining ETF (XME), representing metals and mining companies, returned 6.1% in the past week and an incredible 4.5% on January 6th.

Gold and gold equities have benefited from the decline in the U.S. dollar and an expected pivot by the Federal Reserve. I detailed my thoughts on precious metals companies in a timely note back in late October on Wheaton Precious Metals (WPM) that can be found here.

The big surprise has been the strong moves from other materials companies such as BHP Group Limited (BHP) that returned 4.3% on January 6th, and Freeport-McMoRan Inc. (FCX) that returned 6.1%. With the IMF expecting 1/3 of world economies to be in recession in 2023, it is odd that materials are outperforming. What was behind these strong moves and are they sustainable?

Loosening Chinese Property Regulations Could Benefit Materials

I believe the strong move in materials companies have been driven by news out of China that the government may be ready to ease its 'three red lines' property regulations in order to stimulate its moribund economy.

China's real estate problems are well known and began in 2020, when the government unveiled its 'three red lines' policy designed to deflate a housing bubble. China's policy limited the amount of new debt its property developers could raise, curtailing their frenzied growth plans.

By 2021, the government policies have significantly reduced real estate development activities, and many property developers were on the verge of bankruptcy. Capital.com has good coverage of the crisis with more details for those interested.

As the housing crisis progressed, Chinese policymakers began to have second thoughts and tried to restart lending in its property sector multiple times in 2022. However, Chinese homebuyers were 'once bitten, twice shy' and refused to buy. Some even resorted to boycotting mortgage payments on homes under construction in frustration.

Fast-forward to January 2023, and events appear to be developing as I had predicted in some recent articles on the Templeton Dragon Fund (TDF) and the iShares MSCI China ETF (MCHI). In my TDF article from early November, I wrote:

When China does eventually loosen its covid policies, I believe it will dovetail with stimulus measures to revive its flagging economy and housing sector. With government debt to GDP of only 71%, among the lowest of the major economies, China has a lot of scope to provide stimulus to boost its economy.

In December, we saw China dismantling its Zero-COVID measures in response to mass protest and unrest. Now, we are getting news reports that the government is preparing to loosen restrictions on its property sector. I believe the next step would be for the government to announce concrete stimulus measures to promote real estate and infrastructure investments, similar to the 4 trillion RMB stimulus program China announced in 2009 that amounted to 13% of GDP at the time.

During the years 2009 and 2010 (the time of the Chinese stimulus), the XLB ETF was one of the best performing sector ETFs and massively outperformed the SPY ETF, returning 79% vs. 45% (Figure 8).

Figure 8 - XLB vs. SPY in 2009 and 2010 (morningstar.com)

If history repeats, we could be entering a period of outperformance by materials stocks in the coming quarters on the back of pending Chinese stimulus.

Risk

The biggest risk to my thesis is that the current macro environment is starkly different than in 2009. In 2009, the global economy suffered from a synchronized financial crisis, and governments and central banks enacted stimulus policies around the world. In contrast, in 2023, western central banks are still intent on tightening monetary policies in order to rein in inflation. So even if China stimulates its economy, the effect may be muted by contractions in the western world.

Furthermore, many studies have pointed to the waste and corruption that was associated with the prior Chinese stimulus program. China may be hesitant to unleash a stimulus plan as large and broad as the 2009 stimulus.

Conclusion

The XLB provides broad exposure to materials stocks. Materials look poised to take the market leadership reins from the energy sector, as China appears to be loosening property regulations and getting ready to stimulate its economy.

Disclosure: I/we have a beneficial long position in the shares of WPM, TDF either through stock ownership, options, or other derivatives. 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.