ETF Sector Rotation: Industrials Out, Healthcare In

Some comforting economic data in the U.S. including solid job reports, which in turn spurred faster tapering, and the apparently calming tensions between Russia and Ukraine once again dulled the demand for safe haven assets this month.

This has pushed the interest rates northward as evident by the rise in yields on 10-year treasury notes to 2.79%. The market last saw this level of interest rates in early February.

On the other hand, if we rule out the recent job data and new home sales data in January, the U.S. was thumped with a slew of soft data in the past two months. Though investors held a severe winter (lowest temperatures in a decade) responsible for such downbeat data points, the overall investing sentiment remains cautiously optimistic. Investors might again be interested in investing in stocks – which are riskier investment avenues than treasury bonds – but with great caution (read: Real Estate ETFs in Focus as Rates Turn Higher).

This attitude often calls for sector rotation. The market saw big outflows from industrial ETFs last month while strength was building up in healthcare sector. Let’s dig a little deeper and find out what’s driving this rotation.

Industrials – Out of Favor

Manufacturing data have been on the weaker side to start this year. Though the reading modestly improved in February after a feeble number in January – the slowest pace in eight months and also lower than the median estimate of 56 and the prior-month score of 56.5 – the latest data failed to cheer investors.

Investors are probably looking for some more evidence of continued growth. Notably, the U.S. manufacturing activity in February touched 53.2 bettering the January figure of 51.3 and economists’ expectation of 52.5.

Also, with the interest rates taking an upturn, we expect the sector to slide in the near future. Investors should note that, industrial production is highly vulnerable to interest rates and consumer demand. The industrial sector is moderately capital intensive and requires borrowings to fund its operation. Higher rates will make the borrowings pricier.

On the other hand, consumer sentiment has also been wavering as optimism over long-term job growth and economic self-sufficiency remains seemingly moderate. Slowdown in the world’s second largest economy as well as many emerging nations should also reduce the demand for U.S. made goods.

Investors might have smelled this weaker trend (at least for the near term) as iShares US Industrials ETF (IYJ) and Industrial Select Sector SPDR Fund (XLI) shed $986.5 million and $256.2 million, respectively, in the last one month (read: Industrial ETFs in Focus on Lukewarm GE Earnings).

Healthcare – the Showstopper

Whatever be the market condition, be it bull or bear, healthcare normally holds up well thanks to its defensive nature. Despite an economic slowdown, people spend on medical usage and the sector stays afloat. To add to this, a big-time driver is in place for the U.S. healthcare industry in 2014 in the form of ‘Obamacare’ or ‘Affordable Care Act’.

The space remains a huge beneficiary of this legislation. The Obamacare act was aimed at bolstering the number of insured Americans, which in turn should boost demand for the Pharma and Medicare industry as a whole (read: Obamacare Will Be Amazing for These Stocks and ETFs).

Though the launch of the program had to survive a whole lot of political and technological issues, finally things have fallen into place. More and more people are buying this health insurance plan on exchanges sending the level of uninsured populace to the lowest point since 2009. Apart from this, surging merger and acquisition activities, higher demand in emerging markets, and an aging population are largely helping the sector.

For this reason, Health Care Select Sector SPDR Fund (XLV) has increased its asset base by $770.7 million in last one month, taking a spot in the top-10 assets gatherers’ list. Other healthcare ETFs like iShares U.S. Healthcare ETF (IYH) and Vanguard Healthcare ETF (VHT) attracted $471.4 million and $320.7 million in assets in the said period (read: 3 Top Ranked Healthcare ETFs in Focus).

Bottom Line

Having said this, we would like to note that this rotation might just be a short-term trend. While we really do not expect the healthcare sector lose momentum this year, Industrial ETFs might come out of this difficult scenario. The picture will be clearer when we are fully able to discard the weather-related distortions and see a steady pickup in the global economy.

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