Navigating sectors during recession

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Given the uncertainties of the current economic climate, it is advisable to not solely focus on positioning portfolios for a potential recession or modest growth.

 

OUR view of a recession remains unchanged, and we are expecting a challenging macroeconomic environment in the future.

In this article, we are not trying to time the market, instead, we would like to provide a few options for investors to consider if the recession extends beyond our expectations.

Given the uncertainties of the current economic climate, it is advisable to not solely focus on positioning portfolios for a potential recession or modest growth. Instead, it is recommended to have a well-diversified portfolio that adheres to a personalized strategic asset allocation.

After the cusp of worldwide overheating inflation, global central banks synchronized tightening schedule and pessimistic first quarter of 2023 (1Q23) earnings seasons, the world has started to focus on a brand new topic ‘Recession’.

Furthermore, the collapse of SVB was an unexpected event, with banks, financials and the broader stock market falling sharply, triggering fears of a wider financial contagion. Following the fall of Silicon Valley Bank, Credit Suisse was caught in the aftermath as investors sold down shares of CS following news that their largest shareholder will not be injecting additional capital.

Theoretically, US has already faced a recession in the previous quarters with two consecutive negative GDP, however the professional refused to acknowledge the negative economic growth as a true recession as the market is still, facing unreasonable hefty inflation while the labour market is showing red-hot growth.

According to the market consensus as of March 2023, the market is expecting a 60% recession probability forecast in US, the highest since Covid-19 era. The main reason many experts predict a recession in 2023 is due to the quick action taken by the Fed to raise interest rates and decrease the amount of money in circulation, which tightens overall financial conditions, resulting in:

i) Higher borrowing costs for households and businesses

ii) A negative wealth effect amidst a weakening equity market and higher risk-free rate, where consumers reduce spending

iii) Appreciation of the USD against other currencies leads to a decrease in exports as US is more expensive to foreign buyers, and vice versa, making the domestic import costs higher.

iv) The jittery market sentiment post-SVB’s collapse and Credit Suisse events.

 

Caution, heavy fog ahead!

January is a month full of contradictions. During the US 1Q23 earnings release season, many companies delivered weaker-than-expected results, indicating that slower demand and higher Fed rates are starting to affect companies’ earnings.

As of February 2023, the earnings surprise from the recent 4Q22 earnings release season was largely better-than-expected, beating estimates by 0.57 per cent. The Consumer Discretionary sector led the way with a positive surprise of 10.71 per cent, while the Utilities sector was the worst performer with a negative surprise of minus 2.37 per cent. However, the earnings analysis in the current season is the lowest figure ever since 4Q20.

A look at major US commercial banks, which can act as a proxy for gauging economic resiliency, reveals that although most delivered negative year on year (y-o-y) earnings growth in the recent quarter, the results were still better-than-expected. This suggests that the market may have overreacted to the soaring Fed rate’s impact to combat inflation. Nevertheless, amidst the widely anticipated recession, most US banks accumulated significantly higher loss reserves as a provision for the unprecedented losses that may follow slower consumer demand, along with offering cautious future guidance.

Furthermore, recent earnings reports from tech giants hint at softening demand, particularly for consumer durables such as cars and electronic devices. The pessimistic earnings guidance released by electric vehicle giant Tesla, and electronic devices incumbents Apple and Microsoft provide insight that these companies are expecting a recession in the US. On the retail side, Amazon’s results, as a direct proxy for retail consumption, are also slowing. Additionally, lower revenue growth in the advertisement segment from both giants Meta and Google shows that businesses tend to be more cautious in advertising spending amidst the widely anticipated recession.

 

The moment of decision, diverging paths ahead

Recent earnings releases and slower demand are indicating that we are headed towards a recession, while the strong labor market is suggesting the opposite. Our view of a recession remains unchanged, and we are expecting a challenging macroeconomic environment in the future. As we approach the beginning of a new year, recession signals are flashing bright red. With the inverted yield curve, elevated inflation, and central banks taking measures to curb inflation, the world is on the brink of a global recession.

Amidst escalating geopolitical tensions, unpredictable labour market data, commodity scarcity, and inflation, the US market is facing skepticism about its economic future. Nonetheless, we believe that being proactively prepared is more important than inadequacy. In this article, we are not trying to time the market, instead, we would like to provide a few options for investors to consider if the recession extends beyond our expectations.

 

Hard recession (hard landing)

A severe recession is the most disastrous event for the economy, but it may not be a catastrophic event for the stock market.

To determine if a hard landing is imminent, we need to watch for a decrease in corporate earnings, a spike in unemployment, and a deterioration in earnings guidance. Nevertheless, the loosening and tightening policy by the Fed would be a silver lining in the case of a severe recession to cushion the downside impact for the economy. During a severe recession, consumer demand will be impeded, and the chain effect of corporate layoff processes will cause a higher unemployment rate, as well as slower inflation data. Apparently, a severe recession can help to control inflation, and the Fed may change its hawkish stance earlier than expected. The economically-sensitive sectors, such as materials, industrials, consumer durables, and banks, may not perform well due to softened demand.

However, the change in the Fed’s stance can lead to a V-shaped recovery for some sectors in the stock market ahead. The growth-oriented Tech sector may benefit from such a scenario, as the sector outlook is mainly driven by future prospects instead of the current economic climate. With the lucrative valuation after 2021’s selloff, investing in the Tech sector may be a good idea for investors to capture the rally if the Fed has finally turned down its hawkish stance. Meanwhile, recession-friendly sectors such as healthcare, consumer staples, and utilities, which have been paying dividends for many years, are also good choices, as they tend to be long-established companies that can withstand a downturn.

As such, we recommend investors adopt a barbell strategy which invests in both defensive and growth sectors with similar weightage during a hard landing scenario, to capture the potential rally in growth-oriented counters while providing a comfortable buffer if things do not work as thought.

 

Mild recession

In the case of mild recession where our base case scenario is, it is tougher for investors to position themselves ahead of the mild recession. In this scenario, the corporate earnings and future guidance may decline, similar to the case of severe recession. At the same time, consumer durable goods may be hit badly, as consumers are trying to stockpile savings and reduce unnecessary purchases in order to withstand the recession.

The value-oriented sector might be the best choice during mild recession. Similar reason with what we wrote in ‘hard landing’ scenario, during the mild recession, these defensive sectors are considered more attractive in the downturn environment.

Read more: Rise of the underdog. The comeback of US Value stocks

Furthermore, in the mild recession scenario, the Fed’s interest rates might stay high for longer to avoid the mistake of cutting rates too early, and inflation might rebound from a sudden spike in demand if rates are cut. Based on the assumption of a mild recession, the Financial Services sector could shine as it benefits from a widened net interest margin (higher rates) and better asset quality in a better economy. The healthcare sector, which appears to be a price-setter and less correlated with recessions, may also perform well in this scenario.

Read more: With a global recession in 2023 likely, the healthcare sector is the place to be in

 

No recession

Although no recession seems like the best-case scenario for the economy and the Fed, as it cushions the impact from macro turmoil and soaring interest rates comfortably, it might not be the best course for the market. In this case, a slower-growing economy would slow the pace of inflation, making a rate cut from the Fed less likely.

Businesses with cyclical natures, such as Materials, Consumer Durables, Industrials, and Commodities, may perform well amidst the soft-landing scenario. The pickup in demand, particularly in industrial activities, will boost the demand for raw materials during the early stages of the rebound cycle, while consumer demand could start to accelerate after the bearish market sentiment has gradually diminished.

Additionally, we suggest that REITs could be another sector that may provide a surprising upside. Generally, the REITs sector will suffer as the dividend counter will be less attractive to investors during the higher interest rate environment. However, this time is different. The Fed will try to maintain the interest rate level if the economic growth and inflation rates remain healthy, and eventually, the treasury yield will start to slope downwards. As such, the REITs counter may be aided by the lower yield environment, not to mention the potential capital gain from the recovering economy that boosts the needs for the property market.

Unfortunately, cyclical Tech stocks might not be the best choice under the ‘no recession’ scenario. Although a quick rebound from the trough might appear, the rally might not be sustainable. Despite the better-than-expected economic growth, the main cause of slower semiconductor industry, such as inventory obsoletion, will not be solved in the near future before we see a higher pickup in demand. On the flip side, the TMT (Technology, Media, and Telecommunication) sector, which relies on consumption growth, will nevertheless be impacted by higher Fed rates. However, the silver lining for this sector will be benefited from the still-healthy economic growth, aiding the companies’ earnings fundamentally.

Given the uncertainties of the current economic climate, it is advisable to not solely focus on positioning portfolios for a potential recession or modest growth. Instead, it is recommended to have a well-diversified portfolio that adheres to a personalized strategic asset allocation. This allocation is crafted to navigate market volatility and provide stability amidst the current disruptions.

All in all, by maintaining a diversified portfolio that follows a strategic asset allocation, investors can navigate market fluctuations and uncertainty with more ease, ultimately aiming for long-term stability and growth. We hope the above-mentioned funds could be a viable option for investors to withstand the uncertainties ahead.