Drifting Toward Defensives

by Brad Sorensen of Charles Schwab, 8/29/19

Key Points

  • It doesn’t appear that the U.S. economy is on the cusp of a recession, but a global slowdown and trade disputes have heightened risks.

  • We think it’s time to use market rallies to add modestly to defensive positions.

  • We aren’t changing our official recommendations … yet. There remain potential upsides, but those are slowly being overcome and we may not be far away from an official change.

Recession threat rising?

It doesn’t appear that the U.S. has entered a recession yet, or even that one is imminent—although start dates to recessions typically aren’t known until we’re looking in the rear-view mirror. However, it does appear to us that risks to the U.S. economy have grown, and that the trade dispute with China has dragged on and escalated to the point of potentially having a longer-term impact on economic growth.

We’re also concerned that the Federal Reserve cutting interest rates, as they have done and seem likely to continue to do, will have a limited impact on what is really ailing the economy—corporate uncertainty due to the ongoing trade dispute with China.

As a result of our growing concern, we are suggesting investors use market rallies to add modestly to defensive equity positions, such as the utilities, consumer staples, health care and real estate sectors. We don’t think it’s time yet to load the boat in these areas, as there still remains a possibility of a renewed sustained move higher (which would likely benefit the more-cyclical sectors), but we think it’s prudent to begin slowly adding some defense to your portfolio.

Uncertainty

As I have written before, I would love to be able to make a more definitive call, and we’re getting closer to that point. However, history shows us that markets could turn either way, even after the Federal Reserve cuts interest rates. According to BCA Research, in the year following a rate cut, staples, utilities and health care historically have been the best performers—as you might expect, as the Fed typically cuts when a recession or sharp economic slowdown is feared. However, there have been six instances of what BCA calls a mid-cycle adjustment, where rates were cut, but a recession did not follow. In those instances, the leading sectors were much different: Tech and consumer discretionary were among the leaders, while utilities was the worst performer. Also, while we don’t think a trade deal is imminent, recent history shows us things can change quickly, and if a deal were to occur, we would likely see at least a short-term rally led by more-cyclical areas.

I am also hesitant to go to outperform on the staples and utilities groups, due to some valuation concerns. These areas, along with real estate, have rallied as investors search for yield, resulting in forward price-to-earnings (P/E) ratios of 19.3 for utilities and 19.6 for consumer staples (FactSet). The historical averages for both sectors are 14.8 and 16.9, respectively, according to Strategas Securities. This modest overvaluation compared with historical average causes some concern, but we also believe valuations aren’t to the point of being extreme, and that these groups can go higher if economic concerns rise. I’d also note that health care hasn’t had the run of these other groups, and its forward P/E of 14.8 is right in line with its historical average.