Smith: ETFs For Shifting Scenarios

January 24, 2014

With markets at a crossroad, it’s wise for investors to consider different courses of action.

This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today’s article is co-authored by Anthony Parish, vice president of Research & Portfolio Strategy at Austin, Texas-based Sage Advisory Services, as well as Bob Smith, the firm’s president and chief investment officer.

The consensus among market strategists predicts 2014 will continue along the trajectory that was established in the second half of last year; namely, modest but gradually improving U.S. and global economic growth rates with tame inflation.

In other words, we can reasonably expect economic conditions that are not too hot and not too cold, but just right.

But what if this “Goldilocks” scenario doesn’t play out as scripted?

Investors would do well to have a backup plan, and the vast and still-growing world of ETFs gives investors all the tools they’ll need to plan for and survive the twists and turns ahead.

So let’s get right into it.

If, on the one hand, economic growth is higher than expected, investors could expect the following:

A Flattening Yield Curve

Current belief is to not only shorten duration, but to focus on the front end of the yield curve (one- to five-year maturities), as the intermediate and longer segments of curve would be more vulnerable than the front end, which is locked down by monetary policy.

This thesis may hold true for some time yet, but with the yield curve at historically steep levels, we could envision some curve-flattening as growth continues to improve and the tapering of quantitative easing progresses. While actual Federal Reserve hikes to the Fed funds rate are unlikely for some time, in 2014, capital markets will likely begin to reprice the front end of the curve for that eventuality.

True, cash rates are locked to Fed funds rate, but yields on debt with one- to five-year maturity are not. Therefore, they’re vulnerable to curve flattening in 2014. In this scenario, a barbell strategy makes sense, but with the front end being in cash rates rather than being invested in the one- to five-year sector.

An example would be to combine cash with the iShares 10-20 Year Treasury Bond ETF (TLH | A-69) or the iShares 20+ Year Treasury Bond ETF (TLT | A-72). Depending on the weightings, investors could create an allocation that has a defensive duration and minimizes exposure to the one- to five-year maturity spectrum.

Higher Inflation

There’s still a large amount of slack in the global economy, so the inflation trend has been decidedly muted in the face of an ongoing improvement throughout the global economy. But this is unlikely to persist. Only a modest pickup in inflation would be enough to induce concern.

In this scenario, stocks and bonds could sell off, and inflation hedges such as TIPs and commodities could end up outperforming. Real estate could go either way from a performance perspective.

Signs of building inflation expectations were apparent in TIPS market in December as breakeven spreads moved up 20 basis points. A continuation of this pattern would likely see TIPS outperform nominal Treasurys, prompt a curve-flattening scenario and likely lead to higher commodity returns.

In this scenario, investors may consider exposures in TIPS such as the iShares Barclays TIPS Bond ETF (TIP | A-90), and commodities such as the PowerShares DB Commodity Index Tracking Fund (DBC | B-74).

 

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