Sector Investing

GREATER OPPORTUNITIES FOR GRANULAR RISK MANAGEMENT

2018 was a more volatile year for equities, as the bull market of the last 10 years was kept in check by a Q4 wobble, which saw global equity benchmarks such as the S&P 500 and Nasdaq-100 reset significantly.

As we enter 2019 against a backdrop of U.S. trade war rhetoric, uncertain interest rate outlook and some fears about equity earnings growth, more opportunities and risks will present themselves. This is not only in the performance of the outright market but in the relative performance of sectors within major benchmarks. This relative sector performance can be a significant opportunity for alpha generation, especially if the overall market direction is difficult to gauge.

Indeed, if we look at performance for S&P 500 Select Sectors in 2018, we can see significant dispersion between them and the potential alpha that could be generated by investing between sectors. This also holds true for overlaying a broader portfolio to increase or decrease exposure to a certain sector.

Source: S&P Dow Jones Indices

The performance of the Select Sector Utility Index and Select Sector Energy Index over a 3-month period (26 Sep to 24 Dec) was +0.34% and -29.11% respectively, meaning a spread between the 2 sectors could have potentially netted a 29.45% return.

What sector opportunities and risks may be present in 2019?

Energy:

The energy sector had the worst performance amongst the Select Sectors in 2018. This was on the back of the oil price retrenching by over 40% from its peak in Q4. The U.S. trade war contributed to the negative sentiment, as supply overwhelmed demand. With sector investing, sometimes mean reversion can occur but with the emergence of US shale as a supply factor and the continual growth of renewable energy, investors are likely to have divergent views on the performance of the sector. CME Group’s Select Sector Future (XAE) can be used to manage an investor’s exposure and has seen year over year growth in average daily volume (ADV) of 128% in 2018.

Financials:

Financial stocks responded positively to the Fed’s initial rate hikes in the 2015-17 period and generally outperformed the S&P 500® index. By 2018, however, Fed rate hikes had substantially flattened the US yield curve, undercutting the profitability of banks who profit from borrowing from depositors short-term and lending long-term. A flatter yield curve will likely lead to slower US economic growth, lower bank profits and perhaps, eventually, increased default risk on bank loans. These factors contributed to an 8.4% underperformance on the part of financial stocks with respect to the S&P 500® in 2018.

The fall in energy stocks may have also contributed to the underperformance of financial shares. Banks have extended substantial loans to the energy sector and the fall in crude oil prices raises the risk of default. Financial shares also suffered, at times, during the previous sell off in oil prices between November 2014 and February 2016.

We are in an interesting period where the forecast path of the yield curve will likely have an impact on the performance of the overall market, and an outsized impact on the performance of the financial sector. This risk can be managed via CME Group’s Select Sector Financials Future (XAF).

Indeed 2018 saw more market participants using this product with growth in ADV of 67% over 2017.

Healthcare:

The healthcare sector is traditionally viewed as a defensive sector, where earnings are more stable and thus is a sector which clients turn to in periods of uncertainty. It is a sector which is underpinned by demographic tailwinds as an aging developed world population generates demand for healthcare solutions and services. A headwind facing the sector has been political pressure surrounding pricing and Obamacare-related policies being challenged. Despite these recent obstacles, 2019 may see more clients rotate into this sector if they believe the broader market will continue to have challenging performance as witnessed at the end of Q4 2018. This exposure can be managed via CME Group’s Select Sector Healthcare futures (XAV), which has seen a 2018 ADV growth of 64% over 2017.

Technology:

The technology sector has been the sector which has led the bull market up over the last few years. However, in 2018 the momentum of the sector started to fade as some of the bellwether stocks such as Apple, Facebook and others started to encounter growth issues vs. the market’s forecasts. This also contributed sharply to the pullback in the overall market towards the end of Q4. This has left the sector finely poised as we enter 2019 – will there be a further pullback in the sector or will it reassert its leadership position after a temporary blip? Whatever your view, it should be noted that this sector’s news flow will continue to be heavily focused upon. This will present risks and opportunities which can be managed via CME Group’s Select Sector Technology Future (XAK), which had tremendous growth in ADV of 254% over 2017.

Materials:

Materials stocks suffered in 2018 as the prices of industrial metals, including copper and aluminum, fell. Falling prices reduced the profit margins of the suppliers of these metals. Materials stocks are particularly sensitive to economic conditions in China, which consumes between 40 and 50% of most of the industrial metals and up to two thirds of the world’s iron ore. The U.S. trade war was especially negative for materials stocks.

As views of whether the trade war will abate or not, clients can manage their risk via CME Group’s Select Sector Materials future (XAB), which had an ADV growth of 55% over 2017.

Utilities:

Utilities are highly interest sensitive. They typically pay high dividends and are treated by investors as income bearing investments, akin to bonds. As such, they tend to correlate positively with the prices of US Treasuries and inversely with interest rates. This was the one sector of the equity market that benefitted from the equity market correction which forced the Fed put further rate increases on hold. In 2019, utility stocks could face more headwinds, especially if the expanding US budget deficit causes long-term interest rates to rise. Sector exposure can be managed with CME Group’s Select Sector Utilities future (XAU), which had an ADV growth of 48% over 2017.

Consumer Stocks:

As unemployment continued to fall, consumer discretionary stocks outperformed. The global recovery has been good for the luxury goods business as consumers can deploy their extra income to buy goods beyond basic necessities. Consumer staples stocks, by contrast, turned in a performance much closer to the market averages, seeing much slower earning growth. If the US economy slows significantly in 2019, the relative outperformance of consumer discretionary versus consumer staples could go into reverse, however. Consumer staples stocks sometimes benefit from a flight to safety in slowing economies. Both these consumer sectors can be risk managed via CME Group’s Select Sector Consumer Discretionary future (XAY) and CME Group’s Select Sector Consumer Staples future (XAP), which had 2018 ADV growth of 148% and 55% respectively.

Summary:

Alpha generation opportunities between different sectors’ performance and against major index benchmarks, suggest we will continue to see more rotation between sectors during 2019. At CME Group, there are 11 Select Sector futures available and these provide an effective tool to risk manage sector exposure.

Select Sector

Index Ticker

Futures Ticker

BTIC Block Ticker

Bloomberg Outright

Bloomberg BTIC

2018 ADVT ($ MM)

Correlation vs S&P 500 Index

Communication Services

IXCPR

XAZ

XZT

XASA

XZTA

21.4

0.891

Consumer Discretionary

IXY

XAY

XYT

IXYA

XYAA

82.6

0.929

Consumer Staples

IXR

XAP

XPT

IXRA

XPTA

71.6

0.664

Energy

IXE

XAE

XET

IXPA

XEYA

131.6

0.742

Financial

IXM

XAF

XFT

IXAA

XFTA

222.4

0.864

Health Care

IXV

XAV

XVT

IXCA

XVTA

105.7

0.917

Industrial

IXI

XAI

XIT

IXIA

XIWA

81.6

0.911

Materials

IXB

XAB

XBT

IXDA

XBYA

40.9

0.864

Real Estate

IXRE

XAR

XRT

XARA

XRTA

13.7

0.556

Technology

IXT

XAK

XKT

IXTA

XKSA

135.2

0.945

Utilities

IKU

XAU

XUT

IXSA

XUTA

107.5

0.256

 

*Source: Bloomberg

Average Daily Volume Traded (ADVT) reflects full year 2018. All other data accurate as of December 31, 2018 unless otherwise specified.


 

All examples in this report are hypothetical interpretations of situations and are used for explanation purposes only. The views in this report reflect solely those of the author(s) and not necessarily those of CME Group or its affiliated institutions. This report and the information herein should not be considered investment advice or the results of actual market experience.

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