Eye on the Markets

Defensives Getting Expensive

By Ketu Desai

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In a few days the Fed will most likely raise rates by another 50bps. Perhaps more importantly, the Fed will likely announce its plan for the balance sheet. According to the Fed minutes, the Fed is likely to announce a monthly cap of $95bn, $60bn in Treasuries and $35bn in MBS. This would be almost double the rate of the QT from 2017-2019. The minutes also acknowledged that the MBS could be outright sold. The market will certainly be looking for clarity on outright sales. This more aggressive Fed has sparked a lot of recession fears, in that, the Fed will tighten us into recession. For the near-term, a recession seems highly unlikely. The consumer is simply in a very good situation to expect a near-term recession. Unemployment is low, jobless claims are at historic lows, wages are rising, and the consumer balance sheet is strong.

US household cash exceeds debt for the first time in three decades. Conference Board leading economic indicators has hit an all-time high and points to above trend growth in 2022. The Citigroup economic surprise index is nicely positive. Bank of America’s CEO said, “Don’t fight the U.S. consumer. They are a very strong force and you can see them very healthy. Their loan balances are down, they have plenty of borrowing capacity and they have plenty of spending capacity.” This has been backed up by other earnings reports. American Express reported card member spending growth of 35 percent, with volumes reaching a monthly record in March. Visa reported domestic payment volume up 144 percent versus 2019. Overall, first quarter earnings growth is 7.8 percent, with particular strength from cyclical areas such as energy, materials, airlines, and industrials.      

Besides the strong economy, another positive is that market sentiment and positioning is at historically low levels. During the month, the percentage of bullish investors from the AAII (American Association of Individual Investors) came in at just 16 percent, the lowest in 30-years. Positioning for systematic investors is estimated to be in the 10th percentile, and 20th percentile for discretionary investors. Hedge fund selling, according to JPM, reached greater than 3 standard deviations, mirroring de-risking seen in Q418 and Q120. If there is simply less bad news, there is a lot of positioning that needs to be put on and that could fuel a significant rally. 

The market is now pricing in a lot of Fed tightening. For year-end, the market is pricing in a Fed funds rate greater than 2.5 percent. It is reasonable to expect some leveling-off of inflation due to factors such as the base effects, improvement of the supply chain, reduced demand for goods, and lower used car prices (Manheim used car index off at an annual rate of 18 percent YTD). If that is the case, the market has overpriced certain defensive sectors such as staples and utilities. These sectors seem like an unattractive risk reward. While many staples are great defensive companies, they trade at above a market multiple for slightly better than GDP growth. For instance, Costco trades at 46x, Coke, Pepsi, Clorox, and Proctor at 26x, Colgate at 25x, McCormack at 33x, Hormel at 28x. Similarly, utilities such as NextEra trade at 30x, Xcel at 24x, and ConEd at 22x. Compare that with areas such as energy, materials, and industrials. Energy is expected to have 24 percent longer-term EPS growth trading at just 10.5x. Or materials 16 percent EPS long-term EPS growth trading at just 15.8x. Industrials 9 percent EPS longer-term growth trading at 20x. Even the Nasdaq 100 (QQQ) offers a better value than some of these defensive sectors. QQQ trades at 26x for 14 percent long-term EPS growth or a similar price as many staples for approximately 3x the growth rate.

For the past few months, investors have been de-risking and moving into safety mode, however, we are approaching a point where there is a better risk reward for longer-term investors in areas outside of the defensive sectors.

Looking forward, the market will focus on the Fed meeting, earnings, economic data, and the war.


Ketu Desai is the Principal of i-squared Wealth Management Inc. (www.isquaredwealth.com), an investment management firm based in New Jersey. ketu@isquaredwealth.com