By Paul Broughton, Portfolio Manager
It seems that certain sectors and industry groups in the market haven’t gotten the memo yet that a recession is imminent and are holding up much better than others. Only some sectors are reacting as if a recession is a foregone conclusion and are down sharply for the year. Is one group more correct than the other?
Are we even going to have a recession, and if so, when? That’s obviously TBD. But for now, it would seem that the broad market S&P 500 Index has been anticipating a recession due to its decline this year of -15.1% (and -24% at its low YTD on Oct 12th). What we also know for sure is that highly interest rate sensitive stocks have been hit hard this year as the Fed has been raising rates at its fastest pace since the early 1980s. Specifically, interest rate sensitive stocks such as housing, as represented by the iShares U.S. Home Construction ETF (ITB), are down 26.4%. The Philadelphia Semiconductor Index (SOX) is down 29.3%. And the tech heavy Nasdaq 100, as represented by the Invesco QQQ Trust ETF, is down by over 27.3%.
In contrast, energy, as most probably already know, is the only sector that’s positive this year – it’s up an astounding 74.5% YTD. Every other sector is in the red. The least bad of the rest are both defensive: Utilities and Consumer Staples – both are down 2.3% for the year. Some areas of relative strength that might be surprising to most would be the S&P 500 Machinery Index and the KBW Regional Bank Index, with YTD returns of +1.6% and +1.4% respectively. These numbers look great when compared to the S&P 500’s -15.1%. And this is where the differences are really interesting. Why would regional banks and industrial stocks like John Deere (+19.6%), Paccar (+17.6%), and Caterpillar (+17.1%) be outperforming the broad market if we’re heading into a recession? One could argue that it’s just a late-cycle rally by these groups, but they do tend to behave pro-cyclically and they’re outperforming the broad market nicely.
In the last recession, banks and housing were the epicenter of the financial crisis. Here we are 13+ years later and the banks look particularly healthy overall as we potentially head into an economic slowdown. Where banks were obviously a cause of the recession and a major negative for the recovery coming out of the recession, going into this slowdown they’re a source of strength. They’re well capitalized and still providing funding for the economy. It’s worth noting that they’ve started to tighten lending standards as one would expect within a rising interest rates environment, but they’re still writing loans, seeing positive loan growth and performing well compared to the overall market.
Homebuilders in this current slowdown are less levered and own less land than in the previous downturn and therefore look to be better prepared for slower demand for new home construction. Of course, that weak housing demand is due to the much higher cost of a mortgage. But, the record numbers of millennials seeking housing will not go away because there’s an economic slowdown or recession. That populations will not simply disappear; they must be housed eventually. So, any shortfall in housing demand now means that this underlying demand for housing and new home construction will be deferred further out into the future. The implied point is that the banks and housing are not likely to lead us into a possible recession this time.
The broad market’s decline of -15.1% year to date would seem to indicate that investors are anticipating either a fairly significant economic slowdown or a recession sometime in the next few quarters. Clearly, there are sectors and groups of stocks such as housing and semiconductors that’ve been taken down much more than the S&P 500 for the year. And it’s possible that the relative outperformance of regional banks and machinery stocks is a good omen for the economy avoiding a recession. But the fact remains, until we see inflation move decidedly lower, not just one good reading, the Fed’s current firm policy stance likely isn’t going to change and that means the market volatility and the uncertainty around the timing of a recession or slowdown will remain in place.
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