Investors Turn To Defensive Stocks As Economic Concerns Grow

U.S. stock investors worried geopolitical uncertainty and the Federal Reserve's fight against inflation could dent economic growth are heading for defensive sectors they believe can better weather turbulent times and tend to offer strong dividends.

The healthcare, utilities, consumer staples and real estate sectors have posted gains so far in April even as the broader market has fallen, continuing a trend that has seen them outperform the S&P 500 this year.

Their appeal has been particularly strong in recent months, as investors worry the Fed will choke the U.S. economy as it aggressively tightens policy to combat surging consumer prices. Though growth is strong now, several big Wall Street banks have raised concerns the Fed's aggressive measures could bring about a recession as they work their way through the economy.

The U.S. Treasury market sent an alarming signal last month, when short-term yields on some maturities of government bonds rose above longer term ones. The phenomenon, known as an inverted yield curve, has preceded past recessions. Meanwhile, fallout from the war in Ukraine remains a concern for investors.

"The reason (defensive stocks) are outperforming is people see all these headwinds to growth," said Walter Todd, chief investment officer at Greenwood Capital.

While the S&P 500 has fallen nearly 8% in 2022, utilities have gained over 6%, staples has climbed 2.5%, healthcare has dipped 1.7% and real estate has declined 6%.

With earnings season kicking into high gear next week, defensive sector companies reporting include healthcare giant Johnson & Johnson and staples stalwart Procter & Gamble. Investors will also watch earnings from streaming giant Netflix and electric-car maker Tesla.

Signs that U.S. corporate earnings are set to be stronger than expected this year could bolster the case for other market sectors including banks, travel firms or other companies that benefit from a growing economy, or high-growth and technology names that led stocks higher for most of the last decade.

Defensive stocks have proven their worth in the past. DataTrek Research found that the healthcare, utilities and staples sectors outperformed the S&P 500 by as much as 15 to 20 percentage points during periods of economic uncertainty over the past 20 years.

Lauren Goodwin, economist and portfolio strategist at New York Life Investments, said the firm's multi-asset team has in recent weeks shifted its portfolios toward staples, healthcare and utilities shares and pared back exposure to financials and industrials.

Expectations of a more hawkish Fed have "increased the risk that this economic cycle is shorter and accelerated our allocation shift toward these defensive equity sectors," Goodwin said.

The Fed - which raised rates by 25 basis points last month - has signaled it is ready to employ meatier rate hikes and speedily unwind its nearly $9 trillion balance sheet to bring down inflation. Investors have also been unnerved by geopolitical uncertainty stemming from the war in Ukraine, which has squeezed commodity prices higher and helped boost inflation.

With prices surging, defensive stocks also may be "inflationary hedges to some extent," said Mona Mahajan, senior investment strategist at Edward Jones.

"When you think about where there is a bit more pricing power, consumers will have to purchase their staples, their healthcare, probably pay their utility bills, regardless of the price increases," Mahajan said.

Not all investors are pessimistic about the economic outlook, and many believe momentum could quickly shift to other area of the market if it appears the economy will remain strong.

Art Hogan, chief market strategist at National Securities, puts the chance of a recession this year at 35%, "but it's not our base case."

"As concerns over an impending recession recede, I think the sponsorship of the defensives will recede with that," Hogan said.

The surge in defensive shares has driven up their valuations. The utilities sector is trading at 21.9 times forward earnings estimates, its highest level on record and well above its five-year average price-to-earnings ratio of 18.3 times, according to Refinitiv Datastream. The staples sector is trading at about an 11% premium to its five-year average forward P/E, while healthcare is at a 5% premium.

"It would not surprise me at all to see some mean reversion on this trade for a period of time," Todd said. "But as long as these concerns around growth persist, then you could continue to see those areas relatively outperform."