Recession fears are growing as the Federal Reserve prepares to fight inflation. Many stock market investors are already playing defense and may wonder if these strategies have more leeway.
But first, how worrisome is a recession? Google searches for the term have increased sharply, according to the search giant’s trend data shown below:
The fear is understandable. While the labor market remains robust, inflation, which is at its highest level in four decades, is dragging consumers down, according to sentiment readings.
The Fed is playing catch-up
We see the Federal Reserve belatedly rushing to tighten monetary policy at a breakneck pace – including the potential for multiple outsized half-percentage-point increases in interest rates. It also envisages a much faster liquidation of its balance sheet than in 2017-2019.
Fed officials, of course, say they are confident they can tighten policy and bring inflation down without crashing the economy, achieving what economists call a “soft landing.” There are prominent skeptics, including former Treasury Secretary Larry Summers, whose early warnings of runaway inflation proved prescient.
Keywords: Recession is now the ‘most likely’ outcome for the US economy, not a soft landing, says Larry Summers
Eyes on the curve
And then there is the yield curve.
The yield of the 2-year Treasury note TMUBMUSD02Y,
briefly traded above the yield of the TMUBMUSD10Y 10-year Treasury note,
earlier this month. A more prolonged inversion of this curve measure is considered a reliable indicator of recession, although other measures that have proven even more reliable have yet to flirt with inversion.
Lily: US recession indicator ‘not flashing code red yet’, pioneer yield curve researcher says
The yield curve, even when flashing code red, is not much of a timing indicator for stocks, analysts pointed out, noting that the period between the onset of a recession and a market peak can last a year or more. . Nevertheless, his behavior attracts attention.
Stocks, meanwhile, stumbled last week, which was brought down to four days by Good Friday, as the 10-year Treasury yield hit its highest level since December 2018, the brutal invasion of the Ukraine by Russia continued and the big banks got a earnings season off to a mixed start.
Must know: Default risk, commodity shocks and other things investors need to remember as the war in Ukraine enters a new phase
The Dow Jones Industrial Average DJIA fell 0.8%, the S&P 500 SPX lost 2.1% and the Nasdaq Composite COMP, heavily weighted in rate-sensitive tech stocks and other growth stocks, fell 2. 6%.
Get on the defensive
While only time will tell if a recession is in sight, the stock sectors that perform best when economic uncertainty is on the rise have already significantly outperformed the market as a whole.
“During times of macro uncertainty, some companies/industries outperform simply because they have less risky businesses than the average S&P company,” Nicholas Colas, co-founder of DataTrek Research, said in an April 14 note. Large-cap U.S. utilities, consumer staples and healthcare – often described as the top defensive sectors – all outperformed the S&P 500 SPX,
this year and over the past 12 months.
The S&P 500 was down 7.8% year-to-date through Thursday, while the Utilities sector rose 6.3%, Commodities rose 2.5% and health care fell 1.7%.
Colas deepened its analysis to determine whether these sectors were outperforming by a normal amount for this part of the market cycle. He looked at 21 years of annualized relative return data for each sector, a measure of each group’s performance against the S&P 500 over the previous 253 trading days.
Utilities have posted an average annualized relative performance to the S&P 500 from 2002 to present of minus 2.8%. The 9.9 percentage point outperformance over the past 12 months through Wednesday was just above one standard deviation from the long-term average.
Staples has posted an average annualized return of minus 2.2% versus the S&P 500 over the past 21 years. The 7.6 percentage point outperformance over the past 12 months was just less than one standard deviation from the long-term average.
Healthcare recorded an average annualized outperformance of 0.7% against the S&P 500 over the long term, while the last 12 months of outperformance (10.7%) was just over one standard deviation from compared to the long-term average.
Room to run?
Such robust numbers could naturally give the impression that these sectors could be outperforming, Colas said. But, in fact, their outperformance has been even stronger during recent periods of macro uncertainty, with all three outperforming the S&P 500 by 15 to 20 percentage points.
“Unless you are very bullish on the US/global economy and corporate earnings, we suggest you consider overweighting these defensive groups,” he wrote. “Yeah, they’ve all worked, but they’re not overextended yet if the US/global macro backdrop remains volatile.”
Big Wall Street banks offered mixed results to kick off earnings season, which is in full swing in the coming week. Highlights will include results from electric car maker Tesla Inc. TSLA,
On Wednesday, with investors also worried about whether Chief Executive Elon Musk will face distractions as he pursues his Twitter Inc. TWTR bid,
The economic calendar features a slew of housing data early in the week ahead, while the anecdotal summary of economic conditions from the Federal Reserve’s Beige Book is due Wednesday afternoon.