Defensives may not be safe place to hide as stock market stumbles

[March 04, 2023]  By Lewis Krauskopf

NEW YORK (Reuters) - Investors searching for safer areas in the U.S. stock market are finding that traditional shelters that held up in last year's selloff, such as consumer staples, utilities and healthcare, may be more problematic this time.

After rebounding sharply in January, the benchmark S&P 500 is wobbling again as investors worry the Federal Reserve will take interest rates higher than previously expected and keep them elevated for longer to thwart inflation.

Sell-offs can send investors looking for safety in so-called defensive names, which tend to have solid dividends and businesses that can weather rocky times.

"Last year it was really easy to hide out in defensives," said Anthony Saglimbene, chief market strategist at Ameriprise Financial. “It worked really well last year. I think it’s going to be more complicated this year.”

In the initial weeks of 2023, the argument for defensives has been weakened by evidence the economy remains strong as well as by competition from assets such as short-term U.S. Treasuries and money markets that are offering their highest yields in years.

Sectors such as utilities are known as bond proxies as they typically provide stable earnings and safety in the way government bonds have done in the past.

When compounded by the fact that some defensive stocks carry relatively expensive valuations, investors may avoid them even if the broader market sours.

Utilities, healthcare and consumer staples held firm in last year's punishing markets, posting relatively small declines of about 1%-3.5% as the overall S&P 500 tumbled 19.4% in 2022.

So far this year, those groups have been the three biggest decliners of the 11 S&P 500 sectors, with utilities down about 8%, healthcare off 6% and staples dropping 3% as of Thursday's close. The S&P 500 was last up 3.7% in 2023, but had pulled back since posting its best January performance since 2019.

Fears of a recession induced by the Fed's swift rate-hiking cycle hovered over markets last year, and investors gravitated toward defensive areas, confident of spending on medicine, food and other necessities continuing despite economic turmoil.

Strong recent economic data, including stunning employment growth in January, has prompted investors to rethink expectations of an imminent downturn.

"If you look at the equity market, it’s telling you there’s no recession risk basically,” said Matthew Miskin, co-chief investment strategist at John Hancock Investment Management, adding that defensives so far this year have been a "pain trade."

The floor of the the New York Stock Exchange (NYSE) is seen after the close of trading in New York, U.S., March 18, 2020. REUTERS/Lucas Jackson/File Photo

The health of the U.S. economy is set to become more clear with the release of the February jobs report next Friday, while investors will also be watching Congressional testimony next week from Fed Chair Jerome Powell.

High dividends helped defensive shares as a place to park money in turbulent times over the last decade, especially since traditionally safe assets yielded little. That dynamic changed in the past year as soaring inflation and the Fed's rate hikes pushed up yields on cash and Treasuries.

The utilities sector has a dividend yield of 3.4%, staples stands at 2.7%, while healthcare offers 1.8%, according to data from S&P Dow Jones Indices this week. By contrast, the six-month U.S. Treasury note yields nearly 5.2%.

“You can get a pretty attractive yield in the bond market now, which hasn’t been the case,” said Mark Hackett, chief of investment research at Nationwide.

Meanwhile, valuations in some cases are also relatively expensive. The utilities sector trades at 17.7 times forward earnings estimates, a nearly 20% premium to its historic average, while staples trade at a P/E of 20 times, about 11% above its historic average, according to Refinitiv Datastream.

Healthcare's P/E ratio of 17 times is slightly below its historic average. However the sector's financial prospects this year are relatively weak; S&P 500 healthcare earnings are expected to fall 8.3% against a 1.7% increase for the overall S&P 500, according to Refinitiv IBES.

To be sure, other factors could aid the prospects of defensives. For example, a pickup in volatility in the bond market could improve the lure of defensive equities as a safe haven, said Nationwide's Hackett.

Should concerns about recession spike, as they did last year, defensives could outperform again on a relative basis, according to investors.

Ameriprise is overweight healthcare and staples, said Saglimbene, who sees an uncertain macro environment. But more broadly the firm is underweight equities and is more favorable toward fixed income.

“I think bonds are a better defensive position today than the traditional defensive sectors are,” Saglimbene said.

(Reporting by Lewis Krauskopf; editing by Megan Davies and Deepa Babington)

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