If recent market action has you thinking about using defensive stocks as a way to protect your portfolio against downside risk, you might want to think again.
Defensive stocks can provide a measure of protection in a down market … but not if the reason for the broader-market weakness is concern about Federal Reserve rate hikes.
Here’s why: Investors have poured cash into higher-yielding segments of the stock market, since they’re the only option at a time of low yields for bonds. As a result, defensive investments — including dividend stocks and low-volatility market ETFs — now have a substantial amount of imbedded interest rate risk.
This won’t be an issue if concerns about slower growth come back into the market. However, last week’s flood of positive data adds to the growing body of evidence that the economy is expanding, and that the softness of the first quarter was indeed a result of bad winter weather.
The higher rate sensitivity of defensive stocks was on display last week. On Wednesday, Treasury yields shot higher following the strong second-quarter GDP report. On the same day, the broader market was roughly flat, based on the return of the SPDR S&P 500 ETF (SPY). Still, many defensive investments underperformed on the day:
Naturally, there’s plenty of danger in reading too much into a single day. After weeks of falling Treasury yields, however, Wednesday’s jump in Treasury yields represented a “stress test” of sorts for defensives. On this count, they failed to pass.
There’s nothing to indicate that another move of similar severity is in the offing right now. Nevertheless, the odds of rising yields are clearly higher than they were just a few weeks ago.
On the economic front, growth data has come in above expectations, and personal consumption expenditures (PCE) — the Fed’s preferred inflation measure — has begun to tick up. Sentiment is extended, as outlined here, which raises the odds of a negative reversal. Not least, yields have been rising steadily for bonds with maturities of five years or less. And the five-year Treasury is on the verge of moving out to a new 52-week high.
While it isn’t unusual for the two ends of the yield curve to move in opposite directions, this type of flattening isn’t consistent with a recovering economy. This sets up the long end of the curve for a slump if the data continues to exceed expectations and/or if the Fed gives any inkling at it could raise rates sooner than mid-2015.
This brings us back to defensive stocks.
Low-volatility, higher-dividend stocks will almost certainly underperform the broader market if long-term Treasury yields do indeed begin to rise. And right now, we’re just a few data points away from seeing the tide turn in the bond market.
Don’t fall asleep at the wheel when it comes to dividend stocks, defensive sectors, or low-volatility ETFs. These groups will only provide true “defensive” characteristics if the economy slows down. This might yet prove to be the case, but investors need to be fully aware of the interest-rate bet they’re making with defensives at this stage of the cycle.
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As of this writing, Daniel Putnam did not hold a position in any of the aforementioned securities.