The US economy shrank in the first quarter, adding new weight to worries about a possible recession. Savita Subramanian of Bank of America shares how investors can take a more defensive approach. She says growth is slowing and profit margin pressures are rising, but consumer spending is strong. Fears of a recession have been simmering on Wall Street, but they reached the boiling point this week after the Commerce Department said the US economy actually shrank in the first quarter.
It’s the latest twist in a year that’s been full of surprises — most of them unpleasant.
“What’s changed since January 1? War, GDP cuts, Fed on steroids,” wrote Savita Subramanian, head of US equity and quantitative strategy for Bank of America, in a recent note to clients. The biggest issues are already well-known to investors at this point, but Subramanian says there are some other concerning developments lurking beneath the surface.
“China growth is worsening and other cyclical indicators have rolled over,” she wrote. “This is all against a backdrop of cyclically peaked S&P 500 EPS facing secular margin pressure (de-globalization), still lofty valuations and a Fed taper still in play.”
With all of those different issues at work, she says there’s no single factor that seems to be dictating market returns, and a bet on a specific theme — like growth or inflation protection or corporate tax cuts in years past — seems unlikely to work. But with a recession looking more likely than it did at the start of the year, she says it’s time for investors to get defensive.
To do that, Subramanian upgraded consumer staples stocks by two notches, from “Underweight” to “Overweight.” Companies in the sector are often seen as a good bet during recessions because peoples’ need for goods like breakfast cereal and toilet paper won’t change even if the economy slows. She also sees some potential sources of upside ahead for those companies.
“The sector is near a record underweight by institutional investors, and lessening labor/input cost inflation could benefit margins,” she wrote.
Subramanian and BofA also have top ratings on healthcare, energy, and financials stocks. Subramanian is less optimistic about banks than the other two sectors because they’re more vulnerable in a recession, as lending would likely decrease.
She also downgraded the materials sector to “Underweight.” She recommends underweights on communication services and consumer discretionary stocks as well.
“Materials is exposed to big ticket spending via housing, autos etc, and it has the highest China beta of all sectors,” she wrote.
Investors who want to take her ideas into account can do so by buying individual stocks or by seeking broad sector exposure using exchange-traded funds (ETFs). While Subramanian didn’t recommend any specific stocks or funds, some examples of related ETFs include the Consumer Staples Select Sector SPDR Fund, Invesco KBW Bank ETF, iShares Global Energy ETF, and Vanguard Healthcare Index Fund.
In spite of all the dark clouds looming over the market, Subramanian says there is a lot of good news, too. Consumer spending is high, services spending is growing, there are signs of decreases in labor and raw materials costs for companies, and businesses across the board have strong balance sheets.
Overall, Subramanian reduced her year-end target for the S&P 500 index to 4,500 from 4,600. That implies a rally of nearly 9% from Friday’s closing price, but it would still leave the benchmark index down 5% in 2022.
She says she’s changing her target because both the decline in stocks and the volatility due to interest rates will eventually ebb, which will make investors comfortable accepting a lower risk premium for stocks. Still, she says that the risk of a recession is only partly reflected in equity prices.
“The average peak-to-trough decline in the S&P 500 amid recessions has been ~32%,” she said. “The S&P’s 10% YTD decline can be very roughly interpreted as discounting a one-third chance of a recession (one third of the avg. peak-to-trough decline). If the probability of a recession rises, more downside risk would be expected.”