3 ETF Trends in Q1 2016 (XLU, VNQ)
Three trends in exchange traded funds (ETF) in Q1 2016 are a recovery in rate-sensitive funds, strength in emerging market ETFs and strong flows into precious metal ETFs. Gains in these ETFs are reversals of major trends from the previous year, when low inflation and increases in short-term interest rates combined to put downward pressure on these groups.
One major development crucial to the first quarter of 2016 was the Federal Reserve’s shift to a more dovish policy in response to financial market volatility and weakness in overseas economies. Another major development involved improvements in industrial and manufacturing data, which point to improvements that could pull these areas of the economy out of recession for the first time since 2014. Top-line data remains weak, but new orders are picking up underneath, while inventories have bottomed out. These catalysts have led to rebounds for rate-sensitive sectors, emerging markets and precious metals.
Federal Open Market Committee (FOMC) statements and speeches from Federal Reserve officials in Q1 2016 focused more on growth risks, while being tolerant of increases in inflationary pressures. This led to a revaluation of the timing of the Federal Reserve’s second rate hike and pushed interest rates lower. Adding to downward pressure on interest rates were the aggressive interventions by the Bank of Japan and the Bank of Europe for additional asset purchases and negative interest rates.
These central bank actions led to strong inflows into yield-generating instruments such as utilities, real estate investment trusts (REITs), high-yield bonds and dividend-paying stocks. Falling interest rates spurred investors to lock in yields at current levels. In the first quarter, interest rates on the ten-year bond fell from 2.25% to 1.79%. Such a decline in interest rates is the ideal catalyst for these funds.
The major ETF for utilities, the Utilities Select Sector SPDR ETF (NYSEARCA: XLU), had $1.3 billion of inflows in Q1. For REITs, the Vanguard REIT ETF (NYSEARCA: VNQ) had inflows of $1.2 billion in Q1. In high-yield bonds, the iShares iBoxx High Yield Corporate Bond ETF (NYSEARCA: HYG) had inflows of $1.5 billion in Q1. These ETFs had gains of 16%, 7% and 2%, respectively, in the first quarter.
Accompanying the Fed’s change in tone were some improvements in industrial production data, indicating that the recession may be ending for that sector. Improvements in the industrial sector translate into increased economic activity and increased demand for commodities. Emerging markets are leveraged to commodity prices and global growth as their economies remain export reliant. Additionally, many of these countries, as well as corporations in these countries, borrow in U.S. dollars while earning in their local currencies. Thus, the weakness in the U.S. dollar is a welcome development that eases these countries’ debt burdens.
In turn, the iShares MSCI Emerging Markets ETF (NYSEARCA: EEM) rallied 9.4% in the first quarter. Inflows amounted to $395 million, which compared favorably to outflows of $6.6 billion in 2015. Investor sentiment soured toward emerging markets in 2015 due to weakness in energy prices, a slowdown in global trade and fears of further weakening in China’s economy. Therefore, the marginal improvement in fundamentals for emerging markets in the first quarter is leading to a strong rally as bearish sentiment unwinds. Whether these improvements prove to be sustainable will go a long way in determining the path of emerging markets.
The rally in precious metals during the first quarter is due to many of the same catalysts causing inflows in emerging markets and yield-generating funds. Precious metals are driven by real interest rates, which fell while inflation remained steady and interest rates fell. Additionally, risks surrounding financial conditions increased, especially with many overseas central banks beginning to experiment with negative interest rates in an effort to stimulate economic activity.
Coming into 2016, sentiment for precious metals was particularly low, given its bear market since 2011. Between its peak in 2011 and 2016, SPDR Gold Shares (NYSEARCA: GLD) declined 44%. This ETF was up 14% in the first quarter, with inflows of $5 billion. More leveraged precious metals funds like the Market Vectors Gold Miners ETF (NYSEARCA: GDX) and the Market Vectors Junior Gold Miners ETF (NYSEARCA: GDXJ) were up 46% and 45%, respectively.
The rapid rise in precious metals funds is a sign of how much investors’ expectation for 2016 have already been upended. Market participants came into the year expecting continued weakness in inflation and a hawkish Fed. Instead, inflation numbers have been inching higher, while the Fed has focused more on overseas risks to growth, which has boosted gold as financial conditions have eased. How these factors evolve will determine whether precious metals ETFs can continue their trajectories going forward.