Recession fears mount as the Federal Reserve prepares to fight inflation. Many stock market investors are already playing defense and may be wondering if there is more room for these strategies.
But first, how worried are we about a recession? Google searches for the term are on the rise, according to trending data from the search giant below:
The fear is understandable. While the labor market remains resilient, inflation, which is at a four-decade high, has brought consumers to their knees, according to sentiment gauges.
Fed is playing catch-up
The Federal Reserve is belatedly seeking breakneck monetary tightening — including the potential for several outsized half-a-point rate hikes. It is also considering reducing its balance sheet at a much faster rate than it did in 2017-2019.
Fed officials say, of course, that they are confident they can tighten monetary policy and lower inflation without crashing the economy and achieve what economists call a “soft landing.” There are prominent skeptics, including former Treasury Secretary Larry Summers, whose early warnings of rising inflation proved prescient.
Keywords: A 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 on the 2-year TMUBMUSD02Y treasury note, 2.485%, briefly traded above the yield on the 10-year TMUBMUSD10Y treasury note, 2.843%, earlier this month. A sustained inversion of this measure of the curve is considered a reliable indicator of recession, although other measures that have proven even more reliable are yet to flirt with the reversal.
Read: The US recession indicator “isn’t flashing red yet,” says a pioneering yield curve researcher
The yield curve, even when flashing red, is not a good indicator of time for stocks, analysts have pointed out, noting that the period between the start of a recession and a market top can be a year or more. Nevertheless, his behavior attracts attention.
Stocks, meanwhile, tumbled over the past week, shortened to four days by Good Friday, as the 10-year Treasury yield surged to its highest level since December 2018, Russia’s brutal invasion of Ukraine continued and major banks ushered in the earnings season to a mixed start .
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The Dow Jones Industrial Average DJIA fell 0.8%, the S&P 500 SPX lost 2.1% and the Nasdaq Composite COMP, which is heavily weighted in interest-rate-sensitive technology and other growth stocks, fell 2.6%.
become defensive
Only time will tell if a recession is imminent, but stock market sectors that do best as economic uncertainty mounts have already significantly outperformed the broader market.
“During times of macroeconomic uncertainty, some companies/industries perform better simply because they have less risky businesses than the average S&P company,” said Nicholas Colas, co-founder of DataTrek Research, in an April 14 note. US large-cap utilities, consumer staples and healthcare — often referred to as primary defensive sectors — are all outperforming the S&P 500 SPX, -1.21% year-to-date and 12-month.
The S&P 500 is down 7.8% year-to-date through Thursday, while utilities are up 6.3%, staples are up 2.5% and healthcare is down 1.7%.
Colas delved deeper to examine whether these sectors were outperforming normally during this part of a market cycle. He looked at 21 years of annualized relative return data for each sector, a measure of how each group has performed against the S&P 500 over the past 253 trading days.
The results:
Utilities have posted an average annualized relative performance versus the S&P 500 of -2.8% from 2002 to date. The outperformance of 9.9 percentage points over the trailing 12 months through Wednesday was just over one standard deviation from the long-term average.
Staples has averaged a 2.2% annualized performance against the S&P 500 over the past 21 years. The outperformance of 7.6 percentage points over the trailing 12 months was a little less than one standard deviation from the long-term average.
Healthcare has averaged a 0.7% annualized outperformance versus the S&P 500 over the long term, while the trailing 12-month (10.7%) outperformance was just over one standard deviation from the long-term average.
room to run?
Such robust numbers could understandably suggest that these sectors could outperform, Colas said. In fact, their outperformance has been even stronger in past bouts of macroeconomic uncertainty, with all three outperforming the S&P 500 by 15 to 20 percentage points.
“Unless you are very bullish on the US/world economy and corporate earnings, we suggest you consider overweighting these defensive groups,” he wrote. “Yes, they’ve all worked, but they’re not overwhelmed yet if the US/global macro backdrop remains volatile.”
Upcoming Attractions
Wall Street’s major banks offered mixed results as the earnings season kicked off next week. Highlights include electric-car maker Tesla Inc. TSLA results, -3.66% on Wednesday, with investors also worried over whether Chief Executive Elon Musk will face distractions as he announces his bid for Twitter Inc. TWTR , -1.68% tracked.
The economic calendar includes a slew of housing data early next week, while the anecdotal roundup of Federal Reserve economic conditions is due Wednesday afternoon.