Consumer Discretionary Talk with the Head of Research for SPDR ETFs and SSGA Funds

ETF Database (ETFdb): The general consensus in the markets is that the Fed will raise interest rates in December. Do you believe the Fed will finally pull the trigger and interest rates will begin to rise in December of this year?

Dave Mazza (D.M.): SSGA’s view is that the Fed will raise rates by 25 basis points at the December 2015 meeting, which would be the first hike in nearly a decade. After liftoff in December, we expect there to be a series of four quarter-point rate hikes in 2016.

A Fed move to raise rates would represent a vote of confidence in the US and global economic outlook, as well as for corporate fundamentals, consumers, and credit markets.

ETFdb: If interest rates rise, what sector(s) do you believe will outperform in a rising rate environment?

D.M.: Financial stocks and related industries, including regional banks, have historically benefited from rising rates and a strengthening economy. The early part of the tightening cycle is especially constructive, as higher rates create more room for banks to increase the margins on their loans without stifling demand. Also, banks are generally more willing to lend against a backdrop of improving economic conditions. So, to the degree the Fed’s moves reflect its confidence in the economy, we would expect lending activity to respond in kind. Evidence of this is that consumer loan balance, excluding government-held student loans, finally exceeded the 2008 peak.

ETFdb: The consumer discretionary ETF (XLY A) hit a new 52-week high the first week of November. The consumer discretionary sector is the best-performing sector this year. What macro factors do you believe contributed to this new high?

D.M.: Strong earnings and a resilient consumer have helped XLY this year. The sector is reporting the third highest earnings growth rate at 13.1%. Of the 31 sub-industries in this sector, 18 are reporting earnings growth. Twelve of these 18 sub-industries are reporting double-digit earnings growth.

Consumers’ spirits continue to climb, and did so again in November when the University of Michigan Consumer Sentiment Index rose to 93.1, topping estimates. Consumers are buoyed by cheap borrowing costs and price discounts that may help boost spending as the holiday shopping season approaches.

While low inflation may be complicating Federal Reserve plans to raise interest rates, it’s helping Americans stretch their paychecks further. Not to mention the tailwinds from lower gas prices that are supporting households and their spending habits. The average cost of a gallon of regular gasoline was $2.20 on Nov. 11, according to AAA, which compares with an average $2.46 this year and $3.34 in 2014.

While there might be some negativity around the retail sales number, the overall trend is positive. Also, retail sales do not show the true extent of household spending, which is factored into GDP. It was reported that 7 of 13 major retail categories showed gains last month.

ETFdb: The employment data released last Friday was promising, with the labor market adding 271,000 jobs and the average hourly earnings going up from 0.2% to 0.4% month-over-month. How do you think this contributes to the success of the consumer discretionary sector?

D.M.: The trend in the labor market has been very strong and supportive of a resilient consumer. There are now more long-term jobs than there were at any point since the recession, and this is a big factor of consumer strength.

In addition, we are finally starting to see wage growth pick up, which is another benefit to consumers. Average earnings rose by nine cents an hour and were up 2.5% from a year earlier. While this may seem small, this is faster than inflation, which is running at less than 2% per year. Faster wage growth would suggest that employers are starting to have trouble finding workers and need to pay more to get them or keep them. That, in turn, could start to draw more people back into the job market.

With more Americans earning a wage at a time when import prices and gas prices are down, this only adds to the positive backdrop for consumer spending.

ETFdb: Could you describe other factors in the market that contributed to the out-performance of the consumer discretionary sector YTD?

D.M.: Robust domestic demand and a resilient consumer has buoyed the overall growth pattern of this sector. Given that this is a domestic oriented sector with only 32% of foreign sales, the dollar’s strength did not restrain bottom line growth like some other sectors. In fact, companies with greater than 50% of sales outside the US had -10% earnings growth in Q3, showing how important domestic exposure remains with a strong dollar.

US household formations are up sharply, and that is why in the consumer discretionary space we really like the home builders and household industry. Home builders provide exposure to key healthy US-centric and domestic driven factors. The index that XHB seeks to track has over 60% to non-home construction-related industries, such household retail firms like Home Depot.

ETFdb: Do you think there will be additional opportunities in the consumer discretionary sector this year? Or did investors miss the boat, so to speak, if they didn’t invest earlier in the year?

D.M.: Based on earnings expectations, these trends should continue. As the economy continues to improve and the housing market strengthens, there are still opportunities for this sector to run. Investors have been willing to pay up for growth all year, and we expect that continue. Consumer discretionary is projected to have the highest 2016 EPS growth (15%) of all the sectors.

ETFdb: What other sectors are you bullish on in 2016?

D.M.: We favor health care with a focus on biotech. Health care is another growth sector that has strong earnings and revenue growth projected for 2016. This sector continues to surprise to the upside with regularity and at a rate of over 80%. One of the driving forces of this growth has been the healthy returns from the biotech sector as it continues to have demographic tailwinds, as well as persistent demand from M&A.

Something to watch in Q4 is technology, which is another growth sector that has faced some headwinds due to a strong dollar, but is looking attractive heading into 2016.

Dave Mazza believes the economy is improving, which means certain sectors will be in the lead going into 2016. With the economy improving and rates most likely due to rise this month, the consumer discretionary sector is expected to outperform the broad market. The health care sector, and more specifically, the biotech industry, as well as the technology sector are also looking attractive going into 2016.

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