Winners & Losers In Post-Election Sector Rotation

By most accounts, 2017 promises to be a year of change following an election that delivered a surprising Republican sweep. Markets and investors have been reacting to those results, and adjusting portfolios as they look ahead. David Mazza, head of ETF and mutual fund research at State Street Global Advisors, breaks down some of the ongoing sector shifts, and what it all means going into 2017.

ETF.com: Let’s talk about some of the sector shifts we’ve seen since the election. Perhaps the biggest jump has been in financials. The Financial Select Sector SPDR Fund (XLF) saw record inflows last week. Is that just short-lived market reaction, or is the financial sector poised to do well going forward?
David Mazza: There are some trends that had been emerging prior to the election, and the sweep of the Republican Party acted as an accelerant to certain trends. One in particular is in financials. We've seen record inflows over the past two weeks.

There are still a lot of questions about a Trump administration. But the potential for less onerous regulations—which had been impacting financials—coupled with an improving economy over the past couple of quarters, boosting earnings in certain financial companies, and the fact that we’re looking at a 90% chance the Federal Reserve will raise rates in December … all of those things are adding to investor interest in what had been a significantly undervalued sector across the market. They’ve all helped propel it forward, and potentially could keep up into next year.

ETF.com: What about technology and the action we’ve seen in recent days?
Mazza: There are questions about what a Trump administration would do compared to a Democratic administration when it comes to allowing the tech sector to propel. We’ve seen some profit-taking, as it's been an area that’s done well this year.

As investors look to rotate into areas that have done poorly, they've been using their tech-related gains as a funding mechanism, really, more than it being a reflection of the potential for technology going forward.

ETF.com: What sectors do you see winning and losing in a sector rotation going into the new year and a new president?

Mazza: The first thing we need to get past prior to the inauguration is the Federal Reserve meeting in December. Our expectation is that we may continue to see the trends that have been put in place—rotation out of the bond proxies in the market, out of utilities, staples, real estate, and into the more cyclical sectors, like financials, health care, energy, materials and the like.

We expect the moves in the interest rate market and the dollar to impact equity sectors heading into the Federal Reserve meeting. But depending on the statement by the Federal Reserve and what they may allude to for 2017, you could end up with a bit of a pause across the markets broadly heading into the new year.

ETF.com: We’ve seen impressive performance in small-caps recently. Is that just typical performance in a market rally, or is there something else driving this pickup in demand and in performance?

Mazza: One of the big drivers of small-cap stocks on a relative basis to large-cap stocks is the dollar. They tend to be more domestically oriented than their larger, more multinational peers. As the dollar hit 13-year highs, it's helped sentiment in the small-cap space.

Couple that with the fact that investors are now more comfortable looking at undervalued areas—not just your steady-Eddie growers in the market as some uncertainty has been lifted—you may see small-caps continue to do well on a relative basis to large-caps.

ETF.com: Is that the same argument for picking value over growth going forward?

Mazza: It's very similar. There tends to be, over time, a positive relationship between small-caps doing well and value doing well. The flip side is growth doing poorly and large-caps doing poorly, on a relative basis.

ETF.com: What should investors be considering as they make portfolio adjustments at the end of the year?

Mazza: For tax-sensitive investors, you have to be more nimble than before to capture opportunities to tax-loss harvest. What's doing well or doing poorly might not be what you had expected prior to the election.

Another important element is what we have seen in the fixed-income markets. The election of Trump has effectively turned into another taper-tantrum-type event. Some have called it a “Trump tantrum,” where we’re seeing interest rates and yields move up significantly and bond prices fall, which is counter to many people's expectations.

This is why we're keeping such a keen eye on what the Fed does in December. Expectations for inflation have moved up significantly, and there's less of a risk premia in the fixed-income markets, especially the Treasury market, where investors had really been favoring safety.

Finally we may see a divergence between actions in the U.S. versus overseas, especially with the potential for fiscal stimulus, so we’re advocating investors stay balanced in their fixed-income exposure.

There's a role that fixed income can always play, but in this market, you may want to have balance, depending upon the portfolio, with short-dated and long-dated bonds, and look toward areas where sentiment can turn quickly.

High yield's a great example, where, on a relative basis, it may make sense to shift some of that exposure to senior loans if you still believe the credit markets are attractive. In rising rate environments, loans tend to do much better than high-yield bonds, especially in the short term. Tactically, that could be an opportunity for investors.

ETF.com: What happens if, come December, the Fed does not raise rates?

Mazza: If the Fed surprises everyone—and I think the main theme in 2016 is that it's been a year of surprises—we’re going to see these trends potentially reverse sharply. That’s not our base case.

Their words in this case may speak louder than their actions, because people are going to want to know: ‘How should we think about 2017?’ If they don't take any action, we'll likely see money flow back into the bond proxies, into real estate, into utilities, consumer staples, low vol, you name it, and shift out of some of the more inexpensive areas of the market.

But underpinning this, at least over the past few quarters, is economic growth. It has gotten better than many people had expected, especially at the start of last year when there was a lot of concern about China.

The market is pricing in a move, and we don’t believe the Fed would want to do something contrary to that just because of potential for continued uncertainty and volatility.

ETF.com: So, what’s your broad outlook for 2017?

Mazza: We still expect growth to be low and slow, and inflation to be muted. But the important change is the potential for fiscal stimulus. That actually could improve economic growth relative to what it has been, especially because we can see an increase in government spending.

It's not a done deal that Speaker of the House Paul Ryan will be able to get the broader Republican Party behind some aggressive spending from the stimulus side. But if we see that happen, I think we might accept that this is a regime shift. And that may cause people to want to rethink how their portfolios have been positioned if they were solely focused on wealth preservation and safety, and not as concerned about the potential for inflation and really reflationary forces.

ETF.com: Outside the U.S., what’s on your radar?

Mazza: Investors need to keep an eye on Europe with the Italian constitutional referendum taking place Dec. 4. Expectations have been changing recently. This has a lot of impact across broader Europe as well. We've seen a sell-off in the bond markets, and the Italian referendum is very important for our outlook.

More broadly, it’s been another year where fundamentals have mattered less and geopolitics mattered more in driving markets. The macro continues to matter.

Contact Cinthia Murphy at [email protected]