Recession Fears and the Stock Market — Is It Too Late to Play Defense?

Fears of a recession are growing as the Federal Reserve prepares to fight inflation. Many stock market investors are already playing defense and may be wondering if those strategies have more room to run.

But first, how big of a concern is a recession? Google searches for the term have been on the rise, according to trending data from the search giant shown below:

Google

The fear is understandable. While the labor market remains strong, inflation reaches its highest level in four decades has consumers depressed, according to sentiment readings.

Fed playing catch up

The Federal Reserve looks belatedly struggling to tighten monetary policy at a breakneck pace, including the potential for multiple lopsided half-percentage-point increases in interest rates. It is also looking at a much faster winddown of its balance sheet than it did in 2017-2019.

Fed officials, of course, say they are confident they can tighten policy and reduce inflation without collapsing the economy, achieving what economists call a “soft landing.” There are prominent skeptics, including former Treasury Secretary Larry Summers, whose early warnings about rising 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 on the 2-year Treasury note TMUBMUSD02Y,
2,451%
traded briefly above the TMUBMUSD10Y 10-year Treasury bond yield,
2.829%
earlier this month. A longer inversion of that measure of the curve is considered a reliable indicator of recession, although other measures that have proven even more reliable have yet to flirt with the inversion.

Read: US Recession Indicator ‘Not Flashing Code Red’ Yet, Says Pioneering Yield Curve Researcher

The performance curve, even when flashing code red, not a great time indicator for stocks, analysts have emphasized, pointing out that the period between the start of the recession, as well as the peak of the market, can last a year or more. However, his behavior is attracting attention.

Stocks, meanwhile, fell last week, which was cut to four days on Good Friday, as the 10-year Treasury yield rose to its highest level since December 2018, Russia’s brutal invasion of Ukraine continued, and large banks got earnings season. a mixed start.

I need to know: Default risk, commodity shocks and other things investors need to remember as the Ukraine war enters a new phase

The Dow Jones Industrial Average DJIA fell 0.8%, the S&P 500 SPX shed 2.1% and the Nasdaq Composite COMP.Heavily weighted by rate-sensitive technology and other growth stocks, it slumped 2.6%.

get defensive

While only time will tell if a recession looms, the stock market sectors that perform best when economic uncertainty mounts have already significantly outperformed the broader market.

“During periods 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. US large-cap utilities, consumer staples and healthcare, often described as the main defensive sectors, are outperforming the S&P 500 SPX.
-1.21%
this year and in the last 12 months.

The S&P 500 is down 7.8% year-to-date through Thursday, while the utilities sector is up 6.3%, commodities are up 2.5% and health care is down 1, 7%.

Colas took a deeper dive to examine whether those sectors were outperforming by a normal amount for this part of a market cycle. He looked at 21 years of annualized relative performance data for each sector, a measure of how each group performed against the S&P 500 over the previous 253 trading days.

The results:

  • Utilities posted an average annualized relative return against the S&P 500 from 2002 to the present of minus 2.8%. The outperformance of 9.9 percentage points in the last 12 months through Wednesday was just over one standard deviation from the long-term average.

  • Staples saw an average annualized return of minus 2.2% against the S&P 500 over the last 21 years. The outperformance of 7.6 percentage points in the past 12 months was just less than one standard deviation from the long-term average.

  • Health care outperformed the S&P 500 over the long term by 0.7% annualized average outperformance, while the trailing 12-month outperformance (10.7%) was just over one standard deviation from the long term average.

Room to run?

Such strong figures could understandably give the impression that those sectors may outperform, Colas said. But in fact, its outperformance has been even stronger during recent periods 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/global economy and corporate earnings, we suggest you consider overweighting these defensive groups,” he wrote. “Yes, they’ve all worked, but they’re not too widespread yet if the US/global macro backdrop remains volatile.”

upcoming attractions

Wall Street’s big banks delivered a mixed bag of results to kick off earnings season, which goes into full swing next week. Highlights will include results of the electric car manufacturer Tesla Inc.
TSLA,
-3.66%
on Wednesday, and investors are also concerned that Chief Executive Elon Musk will face distractions as he pursues his bid for Twitter Inc. TWTR,
-1.68%.

The economic calendar presents a series of housing data early next week, while the anecdotal summary of economic conditions from the Fed’s Beige Book is due out on Wednesday afternoon.

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