Fear of recession and the stock market — Is it too late to play defense?

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

But first, how much concern is a recession? Google searches for the term have been steadily rising according to trend data from the search giant shown below:


The fear is understandable. While the labor market remains robust, inflation, which has been at a four-decade high, has consumers down in landfills, according to sentimental readings.

Fed plays catchup

The Federal Reserve is seen delayed in trying to tighten monetary policy at a breakneck pace – including the potential for more, large half-percentage point rate hikes. It is also considering a much faster settlement of its balance sheet than in 2017-2019.

Fed officials, of course, say they are confident they can tighten policies and bring inflation down without crashing the economy and achieving what economists refer to as a “soft landing.” There are prominent skeptics, including former Finance Minister Larry Summers, whose early warnings of rising inflation proved far-sighted.

Keyword: Recession is now the ‘most likely’ result for the US economy, not a soft landing, says Larry Summers

Eyes on the basket

And then there is the yield curve.

The yield on the 2-year government bond TMUBMUSD02Y,
traded briefly above the yield on 10-year government bond TMUBMUSD10Y,
earlier in the month. A more prolonged inversion of this target for the curve is seen as a reliable recession indicator, although other targets that have proven even more reliable have not yet flirted with inversion.

Read: US recession indicator ‘does not flash red’ yet, says groundbreaking yield curve researcher

The yield curve, even when flashing red, is not much of a timing indicator for equities, analysts have stressed, noting that the period between the onset of recession, as well as a market peak, could run a year or more. Nevertheless, its behavior is getting attention.

Shares, meanwhile, fell in the past week, which was shortened to four days on Good Friday as 10-year government yields rose to their highest level since December 2018, Russia’s brutal invasion of Ukraine continued and major banks got the earnings season off to a mixed start.

Need to know: Standard risk, commodity shocks and other things investors need to keep in mind as the Ukraine war enters a new phase

The Dow Jones Industrial Average DJIA fell 0.8%, the S&P 500 SPX fell 2.1% and the Nasdaq Composite COMP, heavily weighted for price-sensitive technology and other growth stocks, fell 2.6%.

To become defensive

While only time will tell whether a recession is on the way, stock market sectors that perform best when economic uncertainty is rising have already performed significantly better than the wider market.

“During periods of macro uncertainty, some companies / industries perform better simply because they have less risky companies than the average S&P company,” said Nicholas Colas, co-founder of DataTrek Research, in a note on April 14. U.S. utilities with large corporations, groceries, and healthcare – often described as the primary defensive sectors – all outperform the S&P 500 SPX,
this year and over the past 12 months.

The S&P 500 fell 7.8% year-to-date through Thursday, while the utilities sector rose 6.3%, staples rose 2.5% and healthcare fell 1.7%.

Colas dived deeper to examine whether these sectors managed with a normal amount for this part of a market cycle. He looked at 21 years of annual relative return data for each sector, a measure of how each group performed relative to the S&P 500 over the previous 253 trading days.

The results:

  • Utilities experienced an average annual relative performance compared to the S&P 500 from 2002 to today of minus 2.8%. The 9.9 percentage points outperformance over the last 12 months up to Wednesday was slightly above a standard deviation from the long-term average.

  • Staples experienced an average annual performance of minus 2.2% over the S&P 500 over the last 21 years. The 7.6 percentage points outperformance over the last 12 months was only less than one standard deviation from the long-term average.

  • Healthcare experienced an average annual outperformance of 0.7% compared to the S&P 500 in the long term, while the last 12 months’ outperformance (10.7%) was slightly above a standard deviation from the long-term average.

Room to run?

Such robust figures could understandably give the impression that these sectors may have surpassed it, Colas said. But in fact, their outperformance has been even stronger in previous periods of macro uncertainty, with all three surpassing the S&P 500 by 15 to 20 percentage points.

“Unless you are very positive about the US / global economy and corporate earnings, we suggest you consider overweight these defensive groups,” he wrote. “Yes, they have all worked, but they are not yet over-extended if the US / global macro background remains unstable.”

Upcoming attractions

The Big Wall Street banks offered a mixed bag of results to kick off the earnings season, which is moving into full swing next week. Highlights will include results from electric car maker Tesla Inc. TSLA,
Wednesday, where investors also worry about whether CEO Elon Musk will be subjected to distractions while pursuing his bid on Twitter Inc. TWTR,

The economic calendar features a range of housing data early next week, while the Federal Reserve’s Beige Book anecdotal summary of economic conditions is released Wednesday afternoon.

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