State Street’s Sector Picks For 2016

Regional banking and health care are some of the sweet spots the firm believes investors should consider for 2016.

Reviewed by: Drew Voros
Edited by: Drew Voros

This month, State Street Global Advisors released its “2016 ETF & Investment Outlook.” caught up with one of the report’s authors, David Mazza, vice president and head of research for SPDR ETFs and SSgA funds, to discuss some of the sectors the firm believes will perform better than others. Let’s talk about why you like the regional banking sector and the SPDR S&P Regional Banking ETF (KRE | A-65) as one of your sector ETFs that investors should consider.

Dave Mazza: When you have low energy prices—particularly low oil—coupled with robust job growth, you find there are certain opportunities. We think regional banks are one of them. They benefit from a more localized economic improvement, since their revenue streams are more local, not necessarily national. When you're actually in the early part of a tightening cycle, higher rates can help with profit margins.

There's a question mark, because short-term rates are moving, and long-term rates may not necessarily move higher. Even with that, though, we expect demand to improve. We’re not just relying on the net interest margin stories; we think there will be increasing demand for home loans and increasing demand for auto loans, as this recovery really moves towards the consumer. Do you see regional banks outperforming big national banks like Citibank, J.P. Morgan and Bank of America?

Mazza: We think regional banks remain a better way to access the recovery than broad-based financials, because many of the major banks still have some pressure from the regulatory environment. The legal environment may be beginning to improve for them, but the regulatory environment—Basel III, Dodd-Frank—continues to weigh on sentiment on those stocks.

Plus, many of the major banks have trading operations. And while we would expect volatility to increase, we know trading of individual equities and in the bond market continues to remain subdued, which impacts them to a much greater extent than what you’d find with regional banks. Your forecast of an increase in demand for mortgages segues into another sector that you highlighthomebuilding, and in particular, the SPDR S&P Homebuilders ETF (XHB | A-44).

Mazza: Those ideas are interconnected. A big part of what we’ve heard for the past few years is a lot of positive sentiment on consumer discretionary names. In some cases, they’re no longer as attractively valued as they once were.

We think a better way to play the consumer is with homebuilders in the housing-related sector. Funds like XHB are more second-derivative housing plays. They're more of your Home Depot or Lowes, where, when someone purchases a first-time home, six months later they're out filling rooms or doing home improvement projects. We think many of those particular companies stand to benefit heading into 2016. Let’s talk about technology, another sector you feel investors should consider, and in particular, the Technology Select Sector SPDR (XLK | A-92).

Mazza: Well there's been an increasing amount of attention paid to some of the larger names, of course. Many of them are associated with the so-called FANG stocks [Facebook, Apple, Netflix, Google] that were one of the only sources driving markets positively in 2015. We think the greater opportunity set continues to be there in a slow-growth environment. Investors will pay extra for earnings growth. And technology is going to be one area where we see that in 2016.

Some of the more innovative technology plays have made their way into something like XLK, which can augment what you may be getting with the more narrowed concentration of the FANG stocks. We expect to see bottom-line and top-line growth in technology. There's been quite a bit of pent-up demand for spending in the technology space, particularly at the corporate level. So your technology thesis is tied to more capital expenditures on the corporate side?

Mazza: Correct. We’re not seeing broad-based retail technology sales necessarily do that well. It’s really concentrated on these must-have items. For corporations, some must-have items are improved cybersecurity or improved technological platforms to make them compete with companies that, frankly, may have been more innovative than they were. Let’s touch on the health care sector, where you spotlight the Health Care Select Sector SPDR (XLV | A-94). Do you continue to expect “Obamacare” to push health care stocks higher?

Mazza: We really want to hone in on areas that can provide some attractive earnings growth. We know there are some head winds out there from the political side, but most of that is going to be concentrated more at the biotechnology or pharmaceutical areas. We think a broad-based health care fund may be a more attractive way to play health care.

Demographics for health care remain positive, particularly for U.S.-based health care firms. We think this is a sector that will see earnings growth in 2016, whereas other areas may actually continue to be compressed. Can you talk about energy, which isn’t a recommended sector of yours? However, there have been pretty heavy inflows into the Energy Select Sector SPDR (XLE | A-92) of late. With XLE down more than 20% for the year, some investors are seeing a value proposition there.

Mazza: XLE has seen some of the best inflows all year of any of our sector products. The money that’s going into the energy space seems to be long-term investors looking at the valuation opportunity. When we look across the market, though, we’re not confident that oil prices have necessarily found a bottom. We think that there continue to be issues with oversupply and questions about demand. And some of the weather-related issues have certainly not helped of late as well.

While the valuation opportunity is attractive with energy, we’re not necessarily looking to step in there yet. If you look at the forward price-to-earnings ratio, energy doesn’t necessarily look very attractive. If I look at trailing earnings, it does. So the expectation for energy companies, we think, may continue to disappoint, while some folks think they may start to see improvement. Let’s move outside the States. I know you consider regions much like sectors in the frame of mind of capturing a larger swath. Where’s the sweet spot outside the U.S.?

Mazza: I think it’s emerging markets, which have been beaten up. It’s difficult to find someone who likes emerging markets. But last year, we launched the SPDR MSCI Emerging Markets Quality Mix ETF (QEMM | D-89), and it slowly raised $85 million.

That’s not necessarily a home run in terms of asset gathering, but it’s interesting in light of the fact that emerging markets are significantly out of favor. A lot of our clients have come to us and said, “Hey, I know I need to be in emerging markets as a strategic allocation. But I'm not necessarily comfortable with just the market-cap-weighted approach.”

So this fund tries to find quality emerging market companies using a rules-based, smart-beta approach. But what it’s really looking to do is find companies that are attractively priced with high-quality balance sheets and high-quality earnings. If you look at the return on equity of those particular companies in emerging markets, it’s the same as what you would have received with the S&P 500, but at a much more attractive valuation multiple.

It’s more of a quality play off the idea that, in the short term, we’ll see some choppiness in markets. So with that, I probably want to be tilted toward more quality names that have better corporate governance, that have improved balance sheets. There are a lot of head winds there that we don’t expect to necessarily go away. So if I need to be [in emerging markets], I want to be there in a bit more stable fashion. And do cheaper oil prices play into that thesis for emerging markets?

Mazza: What’s interesting at the emerging market level is that there are some countries and/or companies that are going to benefit tremendously from cheaper oil. Others are going to be hurt, because they're oil exporters. We expect to see a lot of divergence of returns, as some countries do very well, some countries do very poorly. We saw that this year. We expect it to be the case. This divergence will offer up some opportunities for active management.

But for investors who want a low-cost, passive approach, we think QEMM is particularly attractive, because it’s priced at 30 basis points and gives you access to companies with strong corporate governance and strong balance sheets that are also inexpensively priced. Any other final thoughts going into the New Year?

Mazza: Over the past few years, gains have been relatively easy. Certainly 2011 was a more difficult year. 2015 has turned out to be a more difficult year. Investors may need to ratchet down their return targets. But that doesn’t necessarily mean to go to cash, or that we’re going to be in a bear market.

There's going to be a lot of opportunities, as we were discussing earlier, at the sector-industry level in the U.S. Look for value, but don’t necessarily overpay for value just because the price-to-earnings ratio looks positive. Also, this approach that we have with quality mix could be the ticket for emerging markets.

Drew Voros has nearly 30 years' experience in financial journalism. He was a longtime business editor for the Oakland Tribune and sister papers of the Bay Area News Group, and finance writer for the Hollywood trade publication Variety. Voros' past roles have also included editor-in-chief at and ETF Report.