Sector ETFs Suffer Post-Election Blues

Although a majority of the electorate voted to give President Barack Obama another term, the stock market seems disappointed that voters opted to maintain the status quo in Washington. Since Election Day, the S&P 500 has dropped more than 2.5 percent, with little but gold and Treasuries immune to the decline.

Coal- and defense-related names seem to be faring the worst in the slide, as iShares Dow Jones US Aerospace & Defense (NYSE: ITA) and Market Vectors Coal ETF (NYSE: KOL) are down almost 2 percent and 5 percent, respectively, over the past week.

In the case of coal, the worry seems to be that the president will unleash the Environmental Protection Agency (EPA) on the industry in his second term, cracking down with stricter emission standards.

Given the increased regulatory oversight everyone from coal miners to electricity generators have had to deal with over the past few years, the consensus view is that it will only get worse now that Obama doesn’t have to court donors to fund a reelection campaign. Under regulations issued by the EPA over the past few years, the cost of burning coal has jumped more than $125 billion for electric utilities alone.

Given the huge cost increases already coming down the pike, any further tightening of emission standards will make it cost prohibitive to burn coal, especially since natural gas is still so cheap. With US coal consumption already at a 40-year low, the prospects for the industry aren’t particularly bright post-election.

But while domestic coal demand is likely to continue slowing, globally it remains a critically important fuel. In fact, the International Energy Agency predicts that coal demand will actually increase over the next few years because of the emerging markets.

Even as economic growth in China has slowed, the Middle Kingdom remains a major coal consumer. According to estimates, China produced roughly 3 billion tons of coal last year, but it consumed around 3.3 billion tons, making it both a huge producer and importer. Coal accounts for about 83 percent of the country’s energy consumption.

In fact, our domestic coal industry hopes to stoke emerging market demand for coal by constructing a handful of ports on the West Coast to facilitate exports. Although there are still some political and regulatory hurdles to overcome before a major export program becomes a reality, if the deals finally get done, it would provide much needed relief for the US coal industry.

The outlook for defense stocks isn’t quite as bleak, though the sector faces similar headwinds as the coal industry.

As Congress begins wrangling over addressing the fiscal cliff, the defense industry will be closely watched since it stands to take a massive hit from cuts to Pentagon spending. Of the estimated $1.2 trillion in spending cuts that could begin taking effect on Jan. 1, 2013, about $500 billion will be in the defense budget alone.

While that could potentially crimp profits at companies such as Lockheed Martin (NYSE: LMT) and General Dynamics (NYSE: GD), both major Pentagon suppliers, the odds are good that the cuts won’t be quite that deep. In exchange for any concessions on tax increases, Congressional Republicans will look to shield the Pentagon to some extent, particularly since defense cuts were a major issue in the recent elections.

Much like the coal industry, defense and aerospace companies are increasingly looking overseas for revenue. As countries such as China, which recently commissioned its first aircraft carrier, and India, which has embarked on a modernization program for its submarine fleet, becoming increasingly powerful in their regional spheres of influence, they’re beginning to spend more on developing and upgrading their military capabilities.

Though the Cold War is over, the fact that Russia is working to regain its lost prestige on the geopolitical stage is tweaking nerves in Asia and, therefore, spurring military spending there.

American defense and aerospace companies are eager to claim a share of the growing spending pie, and many have talked about the importance of developing international business as America’s War on Terror seems to be falling down the list of national priorities.

While some export control concerns will have to be addressed–the Pentagon obviously doesn’t want its most advanced weapons systems falling into foreign hands–the US defense industry is already wooing foreign business. Lockheed recently struck a deal to sell 42 of its F-35 Joint Strike Fighters to Japan and will manufacture most of those aircraft in that country. Not only will that boost sales, it will also give the company an on-the-ground presence in the Asia-Pacific region, and many other companies are following suit.

So while coal is likely to remain shaky for some time thanks to the election outcome, look for defense to fare better than expected.

What’s New

Last week, Pyxis Capital rolled out its new Pyxis iBoxx Senior Loan ETF (NYSE: SNLN), the second exchange-traded fund (ETF) to focus on variable-rate, senior-secured bank loans.

While bank loans are typically most attractive in a rising rate environment, lately they’ve been garnering attention because of their yields. For example, PowerShares Senior Loan Portfolio (NYSE: BKLN) has seen its assets swell to $1.3 billion since launching early last year, largely thanks to its almost 5 percent yield.

It’s worth noting, however, that senior bank loans are largely equivalent to junk bonds, since the loans are usually made to highly leveraged companies with sub-investment grade ratings. However, senior loans are higher in a company’s capital structure than most other debt, so holders of senior loans are first in line to be paid in the event of a company’s default. And these loans are typically secured by assets, so they’re seen as a bit safer than the average junk bond.

In addition to higher-than-average income, the variable interest rate carried by bank loans provides a nice insurance policy against any future rate increases. That isn’t a huge concern now, but it is something to consider down the road.

Pyxis iBoxx Senior Loan ETF tracks a basket of the most liquid senior loans that meet outstanding value minimums. It charges a 0.55 percent annual expense ratio.

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