Why a defensive stance on Wall Street may not be safe as the stock market stumbles

Investors have gravitated towards defensive equities, confident that spending on medicine, food and other necessities will continue despite economic turmoil

A trader on the floor of the New York Stock Exchange. The benchmark S&P 500 is wobbling again as investors worry the Fed will take interest rates higher than previously expected. AFP

Investors searching for safer areas in the US stock market are finding that traditional shelters that held up in last year's sell-off, such as consumer staples, utilities and health care, 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 US Treasuries and money markets offering their highest yields in years.

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

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

Utilities, health care and consumer staples held firm in last year's punishing markets, posting relatively small declines of about 1 per cent to 3.5 per cent as the overall S&P 500 tumbled 19.4 per cent.

So far this year, those groups have been the three biggest decliners of the 11 S&P 500 sectors, with utilities down about 8 per cent, health care off 6 per cent and staples dropping 3 per cent as of Thursday's close.

The S&P 500 was last up 3.7 per cent in 2023, but 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 towards defensive areas, confident that spending on medicine, food and other necessities would continue 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.

Defensives so far this year have been a "pain trade", he said.

The health of the US economy will become clearer with the release of the February jobs report next Friday, while investors will also be watching Congressional evidence next week from Fed chairman Jerome Powell.

High dividends helped defensive shares as a place to park money in turbulent times over the past 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 per cent, staples stands at 2.7 per cent, while health care offers 1.8 per cent, data from S&P Dow Jones Indices showed this week. By contrast, the six-month US Treasury note yields nearly 5.2 per cent.

“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 per cent premium to its historic average, while staples trade at a price-equity of 20 times, about 11 per cent above its historic average, Refinitiv Datastream said.

Health care's price-equity 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 per cent against a 1.7 per cent increase for the overall S&P 500, Refinitiv said.

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

Should concerns about recession increase sharply, as they did last year, defensives could outperform again on a relative basis, investors have said.

Ameriprise is overweight health care and staples, said Mr Saglimbene, who sees an uncertain macro environment.

But more broadly, the company is underweight equities and is more favourable towards fixed income.

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