2015 MID-YEAR ETF & INVESTMENT OUTLOOK

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1 2015 MID-YEAR ETF & INVESTMENT OUTLOOK SPDR ETFs and SSGA Funds Research Team David B. Mazza, Head of Research Matthew Bartolini, CFA, Research Strategist Jared Rowley, CFA, Research Strategist Key Points Investors have enjoyed a remarkably smooth ride in recent years but the second-quarter swings in government bond markets and uncertainty over potential Federal Reserve rate hikes could be a preview of more volatility. Indeed, we think the road ahead could be choppier and more challenging. Here, we recap what recent ETF flows hint about how investors are positioned for the second half of 2015, what we think investors might reasonably expect, and how to position portfolios with ETFs for the next part of the cycle.

2 WHAT THE FLOWS ARE TELLING US Equity ETF flows outpaced fixed income, with the lion s share of money flowing to currency hedged ETFs that invest in international stocks as the dollar has surged Bargain hunters used energy sector ETFs to play a rebound in oil prices In fixed income ETFs, investors are tapping asset classes with higher yields and less sensitivity to rising interest rates Figure 1: Flows by Asset Class Asset Category Year to Date ($M) Equity 42,323 Fixed Income 26,259 Commodity 2,682 Mixed Allocation 380 Alternative 70 Specialty 815 Overall, ETFs are on track for another strong year with net inflows of $72.5 billion so far, pushing overall industry assets under management to $2.12 trillion across 1,496 funds. 1 In the major asset classes, investors added risk to their portfolios, with equity flows outpacing fixed income exposures. The noticeable rotation back into equity highlights that the early 2015 outflows from equity may have been driven more by seasonality, as opposed to a reversal in investor sentiment. Within equity ETF flows, a few key themes emerged. Perhaps the most noticeable is that investors are looking beyond US borders for opportunities and more attractive valuations in international markets. This flow trend may also reflect lower-than-expected recent US economic growth. There was a clear rotation to Europe in early 2015 based upon expectations of European Central Bank (ECB) easing, although investors continue to closely monitor the tenuous situation in Greece. Figure 2: Equity Flows by Region Equity Region Year to Date ($M) US -26,243 Global 3,506 Currency Hedged 34,487 International - Broad 13,457 International - Region 4,792 International - Single Country 12,325 Figure 3: Currency Hedged ETFs vs. Dollar Strength Exchange Rate Fund Flow ($B) $105 $45 Digging even deeper within the international equity category, investors flocked to currency hedged ETFs that seek to limit foreign exchange risk in investments denominated in foreign currencies. Currency hedged ETFs enjoyed two strong tailwinds during the first half of the year: the outperformance of international stocks versus the US, and the strength of the dollar. The demand for currency hedged exposures can be clearly linked to strength of the dollar versus its major rivals, the euro and the yen (see Figure 3). $100 $90 $85 $80 $75 Sep Oct Nov Dec Jan 2015 Feb 2015 Mar 2015 Apr 2015 $35 $25 $15 $5 -$5 EURO/USD Spot Rate JPY/USD Spot Cummulative Fund Flows Source: Bloomberg, State Street Global Advisors, as of May 4, Past performance is not a guarantee of future results. State Street Global Advisors 2

3 Turning to US sectors, energy ETFs were the big story. In early 2015, we saw inflows that may have been strongly driven by creation-to-lend activity as short interest spiked. More recently, investors have shown signs of bottom fishing in energy-focused funds after the dramatic sell-off in oil as short interest has fallen and flows continue to increase. Investors have also flocked to healthcare ETFs, a top sector performer this year thanks in large part to an M&A frenzy in the biotech industry and robust earnings growth. Conversely, the outflows from utilities ETFs hint that investors are avoiding this ratesensitive sector. In fixed income ETFs, the flows to corporate bonds and high yield debt in particular tell us that investors continue to search for yield in a low interest rate environment. We also see evidence that investors are exploring nontraditional sectors (such as senior loans and convertible securities) to tailor their fixed income exposure, boost yield, and customize duration and credit risks. This jibes with our view that the next round of growth in fixed income ETFs will be driven by tools that give investors precise exposure to specific fixed income sectors, rather than traditional areas such as US Treasuries and broad benchmarks such as the Barclays U.S. Aggregate Bond Index. Figure 5: S&P Select Sector Index YTD Performance Sector Index Health Care Consumer Discretionary Materials Technology Energy Consumer Staples Industrial Financial Utilities Total Return (%) 4 6 Past performance is not a guarantee of future results. Index returns are unmanaged and do not reflect the deduction of any fees or expenses. Index returns reflect all items of income, gain and loss and the reinvestment of dividends and other income. Figure 6: Flows by Fixed Income Category Fixed Income Sectors Year to Date ($M) Corporate 8,616 8 Aggregate 7,090 Figure 4: Flows by Sector Global Equity Sectors Year to Date ($M) Energy 6,490 Health Care 6,341 Consumer Discretionary 2,552 Materials 547 Telecommunications 304 Thematic 134 Real Estate -199 Government 4,174 Preferred 2,207 Municipals 1,872 Inflation Protected 1,538 Mortgage-Backed 386 Bank Loans 178 Convertible 153 Asset Backed 44 Technology -558 Consumer Staples -1,916 Industrials -2,388 Utilities -2,827 Financial -5,750 State Street Global Advisors 3

4 THE BIG PICTURE We don t think the Federal Reserve will be in any hurry to raise rates Global markets may continue to be driven by central bank policy expectations more than the fundamentals We have a favorable outlook toward credit, REITs and equities; and a negative stance on commodities Developed markets continue to be attractive amid an improving economic backdrop, while investors need to be more selective in emerging markets In the US, we favor cyclicals over defensives, with a tilt towards health care, banks and transportation Figure 7: 2-Year Government Bonds With Negative Yields Country 2-Year Bond Yield (%) Switzerland Denmark Sweden Germany Finland Netherlands France Belgium Austria Ireland Japan Now that we ve recapped the flows and how ETF investors may be positioning for the second half of 2015, we ll offer our own outlook on how things may play out the remainder of the year. Not surprisingly, we think the Federal Reserve will dominate the market narrative. Lower for longer is our base case with the September meeting representing the first realistic chance that the Fed will lift administered rates. Why? On one side of the Fed s dual mandate, the labor market continues to slowly improve, with the unemployment rate falling to 5.4% in April. 2 However, inflation remains below the Fed s target and will likely remain muted until we see price hikes and wage growth. In fact, Fed Chair Janet Yellen has voiced concerns about weakening in core inflation and wages. 3 The Fed may raise rates in 2015 simply to show it can, but we don t expect it will abandon its data-dependent policies or pursue consistent increases, similar to past tightening periods. The real question is what happens after the initial hike in terms of path and pace. Of course, the Fed isn t the only central bank that could shake things up. In this era of unprecedented central bank stimulus, market participants expectations of policy decisions, more than economics or underlying corporate fundamentals, are the persistent driver of returns across the globe. This has led to United States 0.60 Source: Bloomberg, State Street Global Advisors, as of May 12, Past performance is not a guarantee of future results. extraordinary market conditions that defy economics textbooks, such as negative short term interest rates throughout Europe (see Figure 7). This backdrop of accommodative monetary policies and low interest rates continues to drive our favorable outlook toward risk assets, including credit, real estate investment trusts (REITs) and equities. In equities, developed markets continue to be attractive amid an improving economic backdrop. Looking deeper at valuation metrics and earnings growth, Japan and Europe show appeal, but the question is how much of this is due to Quantitative Easing (QE) measures versus sustainable organic growth. Time will only tell if a true economic lift-off can occur. The early moves may have already occurred in both of the regions, which have garnered much of the attention from investors to start Therefore, sustainability is a key measure in these parts of the world as monetary policy cannot be their only hope for the future. State Street Global Advisors 4

5 Figure 8: US GDP Growth US GDP Growth Year over Year (%) Q Q Q Q Q Q Q Q Q Q Q Q Q2 Q3 Q Source: Bureau of Economic Analysis, as of May 13, In emerging markets, the sporadic nature of policies and economies across individual countries renders this broader segment unattractive, even though valuations are below historical norms. We think investors need to be selective and take a more segmented approach in emerging markets. For investors in emerging markets, they should consider small caps, which have the benefit of lower leverage and higher capital efficiency ratios than their large cap peers. At the country level, China looks like a standout despite concerns about slowing GDP, rising defaults, and uncertainty over additional reforms. China s transition to consumer based organic growth and the opening up of the A-share market should help attract fresh capital and propel markets further. Last but not least, the US slumbered through another disappointing first quarter of GDP growth of 0.2%, 4 mirroring the weakness seen in. However, if recent history is any indication of future prospects, a gloomy will be easier to swallow if the growth rate accelerates to the 5% range the next couple quarters. We ve seen this movie before in (see Figure 8). While investors have largely favored international equities so far this year, they shouldn t ignore the US, especially with room for corporate earnings to improve. S&P 500 estimated net profit margins for Q2, Q3 and Q4 are 10.3%, 10.6%, and 10.6%, respectively, with year-over-year earnings growth eclipsing 5% in Q4 as the downdraft in the energy sector is projected to have fully worked its course. In this market, we favor cyclicals over defensives with a tilt towards health care, banks and transportation. We are less constructive on commodities as a whole. The oil market remains volatile, China is transforming away from a manufacturing economy, and the dollar appears to be in a long-term upswing, so commodities remain unattractive to us. That said, we continue to believe that inflation hedging remains paramount for most portfolios. State Street Global Advisors 5

6 ETF IMPLEMENTATION IDEAS Investors can use ETFs, particularly sectors, to position for specific themes such as rising interest rates or a stronger dollar In fixed income, investors can further tailor their exposure for themes such as a flattening yield curve, or consider actively managed strategies to navigate a particularly uncertain rate and credit environment Figure 9: SPDR Sector/Industry ETFs: Foreign Sales and Sensitivity to US Dollar and Rates ETF Ticker $ Index Beta (36M) US10Yr Yield Beta (36M) % Foreign Sales SPDR S&P 500 ETF SPY Utilities Select Sector SPDR XLU Financial Select Sector SPDR XLF Energy Select Sector SPDR Fund XLE SSGA expects full-year US GDP growth to be 3.2% and to be the fastest among developed economies. Strong economic growth has historically boded well for certain assets in general, specifically equities. A growing economy also tends to put upward pressure on interest rates and inflation. SSGA believes there is a high likelihood of a Fed rate hike in Q3 2015, with US inflation accelerating into year-end Accordingly, investors have important decisions to make regarding equity and fixed income positioning in their portfolios. Even with strong economic growth, prospects can vary among various sectors and industries. And as the recovery matures, we could see even more dispersion among sector performance (lower correlations), rather than a rising tide lifting all boats. There have been multiple sector rotations over the past year with different sectors taking the leadership baton, which is normal as a recovery lengthens. Looking ahead, we see some key themes that could favor certain sectors and industries. If rates begin rising, the financial sector and banks in particular may have positive exposures to changing interest rates (see Figure 9). Allocating to these exposures may allow US equity investors to position their portfolios for rising rates. Turning to currency-based themes, US interest rates are currently higher than rates in other regions, particularly Europe and Japan, which has driven the value of the US dollar higher relative to other currencies. SSGA expects this dynamic to remain in place given the expectations for a Fed rate hike. In a strong dollar environment, equity investors can position towards sectors and industries with low amounts of foreign revenue. Figure 9 shows the percentage of foreign sales for certain sector and industry ETFs, as well as sensitivity to US dollar movements. Consumer Discretion SEL SPDR XLY Consumer Staples Select SPDR XLP Health Care Select Sector SPDR XLV Technology Select Sector SPDR XLK Industrial Select Sector SPDR XLI Materials Select Sector SPDR XLB SPDR S&P Bank ETF KBE SPDR Metals & Mining ETF XME SPDR S&P Regional Banking ETF KRE SPDR S&P Transportation ETF XTN SPDR Retail ETF XRT SPDR S&P Pharmaceuticals ETF XPH SPDR Oil & Gas Exploration ETF XOP SPDR Oil & Gas Equip ETF XES SPDR S&P Healthcare Svc ETF XHE SPDR Semiconductor ETF XSD SPDR Biotech ETF XBI SPDR Homebuilders ETF XHB Source: FactSet, Bloomberg, State Street Global Advisors, as of May 12, Past performance is not a guarantee of future results. Furthermore, SSGA expects European and Japanese central banks to maintain accommodative monetary policies for the foreseeable future, which has historically been positive for asset markets. During the past 12 months, the MSCI Europe and Japan indices have appreciated 21% and 38%, respectively, in local terms, 5 which may be evidence that central bank policy is already exerting a positive impact on local stock markets. State Street Global Advisors 6

7 International equity investors may enhance risk-adjusted returns by tilting towards stocks with attractive valuations, strong quality metrics and low stock price volatility within their core equity allocations. Given SSGA s expectation of continued accommodative monetary policies in Europe and Japan, the SPDR MSCI Germany Quality Mix ETF (QDEU) and SPDR MSCI Japan Quality Mix ETF (QJPN) may continue to work well for core exposure to those markets. In fixed income markets, the recent flattening of the US yield curve has demonstrated that interest rates do not shift in a uniform, across-the-board fashion. SSGA believes this flattening will continue, with short term rates increasing in Q3 and long term rates holding steady or even declining. Investors can position for a flattening yield curve by having floating rate exposure to seek to protect against rising short term rates, while also maintaining exposure to long-duration fixed rate exposure to seek to take advantage of any declines in long term rates. Investors can implement floating rate exposure via investment grade notes or senior bank loans, depending on their preferences for credit risk exposure, with SPDR Barclays Investment Grade Floating Rate ETF (FLRN) and SPDR Blackstone / GSO Senior Loan ETF (SRLN). Figure 10: SPDR SSGA Global Allocation ETF (GAL) Exposures Source: spdrs.com, as of May 21, % International Equity US Equity Fixed Income High Yield Cash Global Real Estate 8.92 Inflation Linked Bonds 1.97 Allocations are as of May 21, 2015 and are subject to change without notice. Investors can create their own portfolios using ETFs to target specific levels of desired duration and credit risks. However, there are also actively managed solutions that investors can use for core fixed exposure. With the divergence of growth prospects and monetary policies around the world, active managers with skill in navigating volatile, dynamic markets can potentially add alpha, specifically in the fixed income arena. The heightened level of volatility across asset classes from the aforementioned divergence may continue to provide opportunities for skilled portfolio managers. Specifically, within the fixed income market, the mandate of SPDR DoubleLine Total Return Tactical ETF (TOTL) allows the portfolio management team to tactically position across a broad range of asset classes depending on their assessment of opportunities in the current market. Implementation Ideas Sectors Health Care Select Sector SPDR Fund (XLV) Financials Select Sector SPDR Fund (XLF) Countries SPDR MSCI Germany Quality Mix ETF (QDEU) SPDR MSCI Japan Quality Mix ETF (QJPN) SPDR MSCI USA Quality Mix ETF (QUS) Fixed Income SPDR DoubleLine Total Return Tactical ETF (TOTL) SPDR Barclays Investment Grade Floating Rate ETF (FLRN) SPDR Blackstone / GSO Senior Loan ETF (SRLN) 1 2 Source: US Bureau of Labor Statistics 3 Source: Treasuries Rally as Yellen Sees Low Inflation Declining Further, Bloomberg, February 28, Source: Bureau of Economic Analysis ( advance 2015 estimate). 5 Source: Bloomberg, State Street Global Advisors, as of April 30, State Street Global Advisors 7

8 DEFINITIONS Alpha Excess return relative to a benchmark based on risk-adjusted performance. Beta The tendency of a security s performance to react to a move in a market, such as the US dollar or the US 10-year Treasury yield. A low beta indicates that the security s returns do not have a strong relationship with changes in the US dollar and/or the 10-year yield, while a negative beta means that the security s returns tend to move in the opposite direction of the market. The beta coefficients in Figure 9 are calculated using each ETF s underlying stocks returns and changes in the macro variables. Barclays U.S. Aggregate Bond Index A benchmark that provides a measure of the performance of the U.S. dollar denominated investment grade bond market, which includes investment grade government bonds, investment grade corporate bonds, mortgage pass through securities, commercial mortgage backed securities and asset backed securities that are publicly for sale in the US. MSCI Europe Index A benchmark capturing large- and mid-cap representation across 15 developed market countries in Europe. MSCI Japan Index A benchmark designed to measure the performance of the large- and mid-cap segments of the Japanese equity market. S&P 500 Index A widely quoted benchmark for US equities includes 500 of the largest companies in leading industries of the US economy. The market-capitalization-weighted index covers about 80% of the available US market cap. Yield Curve A graph or line that plots the interest rates or yields of bonds with similar credit quality but different durations, typically from shortest to longest duration. When the yield curve is said to be flat, it means the difference in yields between bonds with shorter and longer durations is relatively narrow. State Street Global Advisors 8

9 ssga.com spdrs.com For public use. State Street Global Advisors One Lincoln Street, Boston, MA T: Important Risk Information The views expressed in this material are the views of the SPDR ETFs and SSGA Funds Research Team through the period ended May 15, 2015 and are subject to change based on market and other conditions. This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected. ETFs trade like stocks, are subject to investment risk, fluctuate in market value and may trade at prices above or below the ETFs net asset value. Brokerage commissions and ETF expenses will reduce returns. Frequent trading of ETFs could significantly increase commissions and other costs such that they may offset any savings from low fees or costs. Hedging involves taking offsetting positions intended to reduce the volatility of an asset. If the hedging position behaves differently than expected, the volatility of the strategy as a whole may increase and even exceed the volatility of the asset being hedged. Passively managed funds invest by sampling the index, holding a range of securities that, in the aggregate, approximates the full Index in terms of key risk factors and other characteristics. This may cause the fund to experience tracking errors relative to performance of the index. Counterparty risk to a derivative or other transaction is a risk based on whether each party will be able or unable to honor its contractual obligations. If a party does not meet its obligations, the Fund will be subject to losses or unable to realize gains. Risks associated with equity investing include stock values which may fluctuate in response to the activities of individual companies and general market and economic conditions. Concentrated investments in a particular industry may be more vulnerable to adverse changes in that industry or the market as a whole. A value style of investing emphasizes undervalued companies with characteristics for improved valuations. This style of investing is subject to the risk that the valuations never improve or that the returns on value equity securities are less than returns on other styles of investing or the overall stock market. Although subject to the risks of common stocks, low volatility stocks are seen as having a lower risk profile than the overall markets. However, a fund that invests in low volatility stocks may not produce investment exposure that has lower variability to changes in such stocks price levels. A quality style of investing emphasizes companies with high returns, stable earnings, and low financial leverage. This style of investing is subject to the risk that the past performance of these companies does not continue or that the returns on quality equity securities are less than returns on other styles of investing or the overall stock market. Foreign investments involve greater risks than U.S. investments, including political and economic risks and the risk of currency fluctuations, all of which may be magnified in emerging markets. Foreign investments involve greater risks than US investments, including political and economic risks and the risk of currency fluctuations, all of which may be magnified in emerging markets. Securities with floating or variable interest rates may decline in value if their coupon rates do not keep pace with comparable market interest rates. Narrowly focused investments typically exhibit higher volatility and are subject to greater geographic or asset class risk. The Fund is subject to credit risk, which refers to the possibility that the debt issuers will not be able to make principal and interest payments. Actively managed ETFs do not seek to replicate the performance of a specified index. These investments may have difficulty in liquidating an investment position without taking a significant discount from current market value, which can be a significant problem with certain lightly traded securities. The values of debt securities may decrease as a result of many factors, including, by way of example, general market fluctuations; increases in interest rates; actual or perceived inability or unwillingness of issuers, guarantors or liquidity providers to make scheduled principal or interest payments; illiquidity in debt securities markets; and prepayments of principal, which often must be reinvested in obligations paying interest at lower rates. Increase in real interest rates can cause the price of inflation-protected debt securities to decrease. Interest payments on inflation-protected debt securities can be unpredictable. Investments in asset backed and mortgage backed securities are subject to prepayment risk which can limit the potential for gain during a declining interest rate environment and increases the potential for loss in a rising interest rate environment. Government bonds and corporate bonds generally have more moderate short-term price fluctuations than stocks, but provide lower potential long-term returns. Select Sector SPDR Funds bear a higher level of risk than more broadly diversified funds. Derivative investments may involve risks such as potential illiquidity of the markets and additional risk of loss of principal. Non-diversified funds that focus on a relatively small number of securities tend to be more volatile than diversified funds and the market as a whole. Investments in small/mid-sized companies may involve greater risks than in those of larger, better known companies. Companies with large market capitalizations go in and out of favor based on market and economic conditions. Larger companies tend to be less volatile than companies with smaller market capitalizations. In exchange for this potentially lower risk, the value of the security may not rise as much as companies with smaller market capitalizations. Bonds generally present less short-term risk and volatility than stocks, but contain interest rate risk (as interest rates rise, bond prices usually fall); issuer default risk; issuer credit risk; liquidity risk; and inflation risk. These effects are usually pronounced for longer-term securities. Any fixed income security sold or redeemed prior to maturity may be subject to a substantial gain or loss. Investments in Senior Loans are subject to credit risk and general investment risk. Credit risk refers to the possibility that the borrower of a Senior Loan will be unable and/or unwilling to make timely interest payments and/or repay the principal on its obligation. Default in the payment of interest or principal on a Senior Loan will result in a reduction in the value of the Senior Loan and consequently a reduction in the value of the Portfolio s investments and a potential decrease in the net asset value ( NAV ) of the Portfolio. Investing in commodities entail significant risk and is not appropriate for all investors. Commodities investing entail significant risk as commodity prices can be extremely volatile due to wide range of factors. A few such factors include overall market movements, real or perceived inflationary trends, commodity index volatility, international, economic and political changes, change in interest and currency exchange rates. State Street Global Advisors 9

10 Investing in high yield securities, otherwise known as junk bonds, is considered speculative and involves greater risk of loss of principal and interest than investing in investment grade fixed income securities. These lower-quality debt securities involve greater risk of default or price changes due to potential changes in the credit quality of the issuer. Actively managed funds do not seek to replicate the performance of a specified index. An actively managed fund may underperform its benchmark. An investment in the fund is not appropriate for all investors and is not intended to be a complete investment program. Investing in the fund involves risks, including the risk that investors may receive little or no return on the investment or that investors may lose part or even all of the investment. These investments may have difficulty in liquidating an investment position without taking a significant discount from current market value, which can be a significant problem with certain lightly traded securities. Standard & Poor s, S&P and SPDR are registered trademarks of Standard & Poor s Financial Services LLC (S&P); Dow Jones is a registered trademark of Dow Jones Trademark Holdings LLC (Dow Jones); and these trademarks have been licensed for use by S&P Dow Jones Indices LLC (SPDJI) and sublicensed for certain purposes by State Street Corporation. State Street Corporation s financial products are not sponsored, endorsed, sold or promoted by SPDJI, Dow Jones, S&P, their respective affiliates and third party licensors and none of such parties make any representation regarding the advisability of investing in such product(s) nor do they have any liability in relation thereto, including for any errors, omissions, or interruptions of any index. Barclays is a trademark of Barclays, Inc. and has been licensed for use in connection with the listing and trading of the SPDR Barclays ETFs. SPDR Barclays ETFs are not sponsored by, endorsed, sold or promoted by Barclays, Inc. and Barclays makes no representation regarding the advisability of investing in them. Distributor: State Street Global Markets, LLC, member FINRA, SIPC, a wholly owned subsidiary of State Street Corporation. References to State Street may include State Street Corporation and its affiliates. Certain State Street affiliates provide services and receive fees from the SPDR ETFs. ALPS Distributors, Inc., a registered broker-dealer, is distributor for SPDR S&P 500, SPDR S&P MidCap 400 and SPDR Dow Jones Industrial Average, and all unit investment trusts. ALPS Portfolio Solutions Distributor, Inc. is distributor for Select Sector SPDRs. ALPS Distributors, Inc. and ALPS Portfolio Solutions Distributor, Inc. are not affiliated with State Street Global Markets, LLC. Distributor: State Street Global Markets, LLC is the distributor for all registered products on behalf of the advisor. SSGA Funds Management has retained GSO Capital Partners, & DoubleLine Capital LP as the sub-advisor. DoubleLine is a registered trademark of DoubleLine Capital LP. Before investing, consider the funds investment objectives, risks, charges and expenses. To obtain a prospectus or summary prospectus which contains this and other information, call or visit spdrs.com Not FDIC Insured No Bank Guarantee May Lose Value State Street Global Advisors 2015 State Street Corporation. All Rights Reserved. ID4456-IBG Exp. Date: 06/30/2016 IBG.ETF.MYO.0615