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GICS Sectors after the Brexit: Yield ETFs in Focus

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Jun. 27 2016, Published 9:57 a.m. ET

Cross-asset relationships turned upside-down post-Brexit

The post-Brexit cross-asset volatility we saw on Friday is very likely to persist. After all, the United Kingdom’s decision to leave the European Union means uncertainty for international trade, politics, and revenue prospects for multi-national corporations. Plus, one member leaving the European Union sets a dangerous precedent and may lead to more countries scratching their heads about the benefits of their own European Union memberships. Naturally, investors on an institutional and sovereign level are likely to pull out some money from Europe and move some assets into the United States—a theme we touched on in Part 1 of this series. Consequently, areas that could see especially high volatility are interest rates and, of course, currencies.

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Some of the extreme moves on Friday affected the US Treasury yield curve. Then ten-year yield plunged all the way to the 1.4% level before bouncing back a tad. More importantly, federal fund futures—especially longer-dated ones such as the December contract (FFZ6)—skyrocketed. This change crushed probabilities of a rate hike from the Fed this year and actually brought a rate cut possibility back to the table. 

But we need to understand that everything is relative. While these moves would have hit the US dollar hard in the pre-Brexit world, the currency actually strengthened. The United States is now perceived as a safer place to invest in than Europe or emerging markets. The upside move in the US dollar reflects in the PowerShares DB US Dollar Index Bullish Fund (UUP) jumping 1.6% on the week—its largest weekly upside move this year.

Two rate-sensitive sectors that should remain in focus are financials (XLF) and utilities (XLU). Interestingly, these sectors were among the top three GICS sector ETFs that witnessed inflows during the past week.

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Financials (XLF): Positioning for long-term upside

The Financial Select Sector SPDR Fund (XLF) sold off the most within the GICS sector ETF category on Friday, closing 5.4% lower. The ETF saw the largest inflows, as the chart above shows. There are probably two reasons for the inflows last week.

  1. One day before the Brexit news hit the tape, it was announced that big Wall Street banks passed the first round of the Fed’s stress test. These results are a big long-term positive for names that are weighted heavily within XLF, such as Bank of America (BAC), Citigroup (C), and Wells Fargo (WFC).
  2. The Brexit uncertainty is now out of the way, and global banks can start making concrete long-term transitioning plans for their European operations. In this light, the inflows we saw are likely an investment in the long-term prospects of XLF.

Utilities (XLU): The chase for yield continues

On the opposite side of Friday’s return spectrum stood the Utilities Select Sector SPDR Fund (XLU). In fact, it was the only GICS sector ETF that posted a gain for the day. The move higher was supported by ~$400 million in inflows as investors continued to favor the high-yielding and stable Utility ETF. XLU currently benefits in two ways.

  1. As the ETF closed at another all-time high on Friday, it remains a momentum play. Any investors who haven’t benefited from the rally in utility stocks are likely to chase after its returns going forward.
  2. The inverse relationship between XLU and US yields has become increasingly visible over the past year, as you can see in the spread between XLU and the two-Year US Treasury yield.

Be that as it may, the all-but-certain Brexit reminded us that non-events still have the potential to become market movers. But, most importantly, investors are well advised to analyze the impact of emerging or intensifying cross-asset market relationships on their portfolios.

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