Yesterday, I wrote a piece saying that investors shouldn’t get too carried away with all the scary headlines that seem to be around right now. I stand by that, but neither should investors ignore the possibility of a significant slowdown, or even maybe an actual recession, both here in the U.S. and in other developed nations at some point later this year. I don’t believe the Fed will change course next week, but even if they do, they have hiked interest rates significantly over the last year and are actively trying to slow down the economy. As a rule, what the Fed wants, the Fed gets, so it is fair to assume that growth is going to slow.
That means that while fear engendered by problems at some regional banks is most likely just that -- fear -- investors still have to adapt to an outlook very different from that to which they have become accustomed. However, for long-term investors, particularly those who invest on a regular basis, stopping and sitting on cash is probably not a great option, either. The whole point of long-term dollar cost averaging is to buy on dips as well as rallies, so stopping because there is fear in the air would defeat the object of the exercise. If you cannot rely on economic growth to drive stocks, where should investors be deploying cash?
There are three sectors of the market that are generally considered to defensive when the economic outlook is uncertain: utilities, consumer staples, and healthcare. The feeling is that consumer spending in those areas is resilient. No matter what, we need heat and light in our homes, we all have to eat, and we will continue to get sick, so while stocks in those three sectors won’t escape unscathed if the economy slows significantly, they should, in theory, outperform the market.
One of those, however, doesn’t really suit current circumstances. Stocks in utility companies derive at least part of their value from typically high dividend yields. With Treasury and other bond yields climbing as rates go up, that part of their value proposition is lessened. There are other things like lower energy commodity costs that will help utility companies in a slowdown, but that diminishing value of a dividend yield will more than offset that and makes the sector not a great place to hide in this specific instance.
That leaves consumer staples and healthcare, to which I would add another sector in the current environment, defense. While I don’t believe, or maybe just don’t want to believe, that an all-out word war will ever be seen again, the geopolitical situation right now is anything but stable. Drone battles and balloon bust ups may turn out to be nothing more than Russia and China trying to create uncertainty in order to influence next year’s election or whatever, but they do constitute a strong argument for defense contractors seeking funding. It is therefore not a surprise that, despite America having by far the world’s largest military budget, calls to increase spending on weapons have been predictably heard over the last few months.
As for what to buy in those three sectors, I don’t think this is a time to overthink things. What you are trying to do here is to buy areas of the market that will be resilient, not find individual stocks with a big upside, and in that situation, sector ETFs make sense, at least in the consumer staples and healthcare sectors. They diversify single-company risk and provide exposure to the whole sector. That may limit the upside, but it also controls the downside, which is the point here.
In consumer staples, for example, the SPDR fund, XLP, which includes only large cap companies, is probably a bit better suited to the task that the Vanguard version, VDC, that includes some small- and mid-cap stocks. In healthcare, the choice is simpler, with the big funds XLV and VHT being the obvious choices.
Things get a bit more complicated when it comes to defense, though, because most defense sector ETFs are actually “aerospace and defense” funds because that is the major index that they track. The problem here is that a big exposure to a company like, say, Boeing (BA), which make commercial as well as military aircraft, leaves you exposed to exactly what you are trying to avoid. Travel spending drops in a recession, and airlines then tend to cut back on new aircraft. For that reason, defense is one area where I would prefer single stock buys, such as Raytheon Tech (RTX), that are more purely focused on defense.
Over the last week or so, even the one certainty that traders and investors thought they knew, that the Fed would continue to hike rates for a while, has been called into question, and some of the “hidden” negatives of the rate hikes that have occurred so far have been made all too clear. That and enhanced geopolitical tensions have led to uncertainty, and in an uncertain market, defensive plays like healthcare, consumer staples and defense are where investors’ focus should be. The above would be my suggestions, but whatever you choose to use, favoring those sectors until the outlook is clearer will make sense.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
Martin Tillier
Martin Tillier spent years working in the Foreign Exchange market, which required an in-depth understanding of both the world’s markets and psychology and techniques of traders. In 2002, Martin left the markets, moved to the U.S., and opened a successful wine store, but the lure of the financial world proved too strong, leading Martin to join a major firm as financial advisor.
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