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Aug. 16, 2019, 1:40 p.m. EDT

The ETFs that outperform the broader stock market (and one to avoid) when the yield-curve inverts, says BAML

BAML says investors should consider the energy sector if bonds go pear shaped

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By Mark DeCambre, MarketWatch


LightRocket via Getty Images
A key measure of the bond market has inverted

The investment atmosphere feels as if it has been turned on its ear, a day after long-term bond yields fell below that of their shorter-term counterparts, triggering fresh recession fears on Wall Street.

And although equity markets saw one of the worst declines of 2019 on Wednesday, highlighted by an 800-point tumble for the Dow Jones Industrial Average /zigman2/quotes/210598065/realtime DJIA -0.95% , some strategists say there are investments that could outperform in an environment in which the U.S. 2-year Treasury note yield /zigman2/quotes/211347045/realtime BX:TMUBMUSD02Y 0.00% trades above the 10-year Treasury note yield /zigman2/quotes/211347051/realtime BX:TMUBMUSD10Y 0.00% as it did on Wednesday briefly, for the first time in over a decade.

According to Bank of America Merrill Lynch’s strategists, including Mary Ann Bartels, investment and exchange-traded fund strategist, there are a few ETFs that could do better than the market in the year after an inversion takes place.

The strategists note that the energy sector has outperformed the broader market 80% of the time in the 12 months after a yield-curve inversion of the two-year and 10-year Treasury since 1965, with an average gain of 7.3%. BAML analysts say that the Energy Select Sector SPDR ETF /zigman2/quotes/206420077/composite XLE -0.52%  may be the best vehicle for energy exposure.

The analysts note, however, that the trade conflict between the U.S. and China could be one factor that could cause the sector to break its historical trend (or to at least look out for) because worries about the impact of the tariff dispute on the global economy could hamstring crude-oil appetite.

The XLE, referring the energy ETF’s ticker, has lost 2.2% so far this year and 10% over the past month. By comparison, the Dow gained 9.4% in the year to date but lost 5.1% this month, the S&P 500 index /zigman2/quotes/210599714/realtime SPX -0.39% has climbed 13.5% in 2019 thus far and slipped by about 4.5% in August, while the Nasdaq Composite Index /zigman2/quotes/210598365/realtime COMP -0.83% has gained 17% so far this year but has given up 5% month to date.

The BAML strategists say information technology tends to outperform the broader market when the yield-curve inverts and holds up well in the latter stages of a waning bull-market cycle.

“Specifically, tech is the most globally exposed sector to the factors that perform the best at the end of bull markets - momentum and growth. Strong balance sheets are also a positive. Risks are valuations, positioning and trade,” BAML wrote.

The researchers highlight the Vanguard Information Technology ETF /zigman2/quotes/207654339/composite VGT -1.06%  as a good vehicle to gain tech exposure while it has a limited weighting to the trade-sensitive semiconductor sector /zigman2/quotes/210598361/realtime SOX -1.06% , which have been whipsawed by Sino-American trade tensions.

As far as ETFs and sectors to avoid, BAML says consumer-discretionary shares have a history of underperformance when the two-year yield rises above the 10-year. The average underperformance has been 9.1%, the strategists said, as gauged by Consumer Discretionary Select Sector SPDR ETF /zigman2/quotes/200844504/composite XLY -0.20% . The consumer discretionary ETF has declined 5.2% in August but is up 15.6% in the year to date.

The so-called inversion of the main measure of the yield curve, or a negative spread between short-term and long-term yields, has preceded the last seven recessions. However, a recession doesn’t happen instantly when a yield-curve inverts. From 1956, past recessions have started on average around 15 months after an inversion of the 2-year/10-year spread occurred, according to BAML.

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Mark DeCambre is MarketWatch's markets editor. He is based in New York. Follow him on Twitter @mdecambre.

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