Defensive stocks have traded poorly this year, but this strategist says they are in a sweet spot

By Isabel Wang

A 'growth scare' will push Treasury yields lower and increase demand for safe-haven assets in equities: Sevens Report Research

U.S. stocks in the underperforming defensive sectors may be due for a comeback in the coming months as fears of an economic slowdown will push Treasury yields lower and increase demand for safe-haven assets in equities, according to Sevens Report Research.

"I do believe that we will have an [economic] growth scare in the coming months. That doesn't mean I'm saying we'll have a recession, but I do believe we have a growth scare looming and as such, I will begin to 'nibble' on utilities, staples and healthcare on the long side starting today, and I'll rotate out of cyclicals as they've benefitted from solid growth and higher rates," said Tom Essaye, the founder and the president of Sevens Report Research, in a Tuesday note.

Defensive stocks in the utilities, healthcare and consumer staples sectors were under pressure in the past month as Treasury yields climbed after the U.S. government averted a shutdown and after investors expected the Federal Reserve to keep interest rates higher for longer as the U.S. economy remained strong.

See: Utilities stocks suffer worst day since 2020 as Treasury yields resume climb

Stocks on the utilities, healthcare and consumer staples sectors are often referred to as "bond proxy" equities where their higher dividends helped replace lower bond yields over the past several years. However, they have become less attractive when the yields of some risk-free assets have started rising, making the defensive stocks less attractive compared with the U.S. Treasury bonds and money-market funds.

The S&P 500 Utilities Sector XX:SP500.55 has dropped nearly 17% so far in 2023, while the Healthcare Sector XX:SP500.35 was off 3.6% and the Consumer Staples Sector XX:SP500.30 has lost 8.5% over the same period. On the other side of the spectrum, the technology-heavy S&P 500 Communication Services Sector XX:SP500.50 has jumped 45.4% and the Information Technology Sector XX:SP500.45 has risen 38.5% this year, according to FactSet data.

The underperformance of defensive sectors has resulted in some stocks trading at valuations last seen before the pandemic, Essaye said. For example, the utilities sector was trading at a forward price-to-earnings ratio (P/E) of 14.7 as of Tuesday, which was the lowest level since 2018. Consumer staples sector, meanwhile, was trading at a P/E ratio of 18. That was also the lowest level since before the pandemic, according to Sevens Report Research.

"Point being, both of these sectors are cheap on a longer-term basis and in a market where not a lot is cheap on a multi-year basis, that is notable," Essaye said.

Essaye thinks their low valuation is "just part of" the reason why defensive stocks are attractive, and the real question is whether investors think there will be a real economic slowdown weighing on the Treasuries, pushing yields lower and increasing demand for companies in the defensive sectors that are nearly always in demand, even during an economic downturn.

"Now, it's entirely likely I'm very early on this 'growth scare' idea, which is why I'm only 'nibbling' on the long side, but if we do get a 'growth scare,' then that will be positive for these defensive sectors and longer-dated bonds, and I think the risk-reward in both, given recent declines, is finally attractive," he added.

See: Will Israel-Gaza war sink stocks and shake the global economy? Watch oil prices.

U.S. stocks finished higher on Monday as Treasury yields BX:TMUBMUSD10Y retreated after geopolitical uncertainty around the Israel-Hamas conflict rattled investors. The S&P 500 SPX rose 0.5%, while the Nasdaq Composite COMP was up 0.6% and the Dow Jones Industrial Average DJIA advanced 0.4%, according to FactSet data.

-Isabel Wang

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10-10-23 1736ET

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