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).

 

Upside Surprise In Emerging Market Stocks

Emerging markets (EM) are largely expected to underperform developed markets in 2014, despite steep underperformance in 2013; attractive relative valuations; and a generally stabilizing macro picture.

Market sentiment could shift later in 2014 if EM economies show further evidence of stabilizing and less downside impact due to Fed tapering. EM equities also have lower earnings bogeys to beat than their developed-market counterparts.

The upside for EM equities is large given higher beta characteristics and a 54 percent underperformance versus the S&P 500 Index over the last 2 1/2 years. For this segment of the market, our choice would be the Vanguard FTSE Emerging Markets ETF (VWO | B-85).

Commodities Appreciate

Commodities are expected to do better than they did in 2013, but still overall underperform equities by a fairly substantial margin due to a strong dollar, low inflation and better equity sentiment. The complete lack of inflationary concerns is unlikely to persist given improving global growth.

The dollar may not appreciate as expected, thereby creating a weaker head wind for commodities. Like EM, commodities have underperformed equities by a wide margin over the past 2 ½ years (60 percent). The opportunity in commodities could range from a diversifier that doesn’t lag other risk assets, to meaningful outperformance, especially if inflation picks up and equity markets stall.

So far, all of the discussion above has focused on the possibility that economic growth could be more robust than expected. Of course, economic growth could prove to be lower than expected.

In that scenario, investors could expect a redux of the past three years, including:

1) The continuation of stimulative monetary policy from the Fed and other central banks. This would almost certainly call into question the efficacy of the Fed’s monetary policies and cause volatility in the markets.

2) The not-so-great rotation. Consensus view is to limit exposure to core fixed income given rising yields and a great-rotation scenario. If economic growth turns out to be lower than expected, core fixed income could surprise investors, as yields would likely rise less than they did in 2013.

Clearly, there are several types of large institutional investors such as insurance companies, pensions, etc., that will continue to hold fixed income at levels consistent with their businesses. For other types of investors who are more tactical in nature, the opportunity would be that actively managed core fixed income could still provide the best hedge to a macro downside scenario.

Although investors can generate the same level of income as the core bond market by using noncore securities (such as high dividend equities, for example), those income substitutes do not provide the same diversification or low-volatility characteristics as diversified core fixed income. In other words, just because you can get a 3 percent yield from a stock fund or a bond fund, you shouldn't expect the stock fund to be as defensive if the economy hits a soft patch.

In any case, 2014 will likely be a year in which investors will have to pay close attention to market developments and be ready to shift allocations as events unfold.

Thankfully, ETFs offer the perfect tools to maintain flexibility.


Sage, an independent investment management firm, serves institutional and private clients with traditional fixed-income asset management and global tactical ETF strategies. Sage began using ETFs in 1998, and today offers a range of tactical all-ETF solutions, including income-focused and target-risk global allocation strategiesContact Sage at 512-327-3330 or sageadvisory.com.



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