Defensive stock sectors such as utilities, real estate, and consumer staples have been leading the market in recent months, and these sectors still have big upside ahead in the face of the protracted trade conflict with China, and growing concerns that the U.S. economy may be headed toward recession. "We’re moving from the perception that this is late-cycle to a belief that it’s end of cycle," said Mike Wilson, chief U.S. equity strategist at Morgan Stanley, in a new report, adding, "During the most recent growth scares in late 2015/early 2016 and 4Q18, the defensive cohort outperformed secular growth by 25%. So far, the outperformance has been around 12%, or about half of what I expect to see before it’s over."

Significance For Investors

Wilson continues: "In the past year, defensive stocks and bonds have been the place to be, not growth stocks, particularly on a risk-adjusted basis. While growth stocks resumed their leadership during the first half of the year, they relinquished it again in mid-July, which is when the positive correlation between bonds and stocks reversed."

For the year ending on Sept. 30, 2019, the S&P 500 Index (SPX) rose by just 2.15%, while utilities gained 22.90%, real estate advanced by 20.68%, and consumer staples were up by 13.42%, per S&P Dow Jones Indices. Meanwhile, S&P 500 growth stocks gained a mere 1.68%. The year-to-date figures for 2019 show smaller differences in performance, but defensives have continued to lead: S&P 500 +18.74%, utilities +22.29%, real estate +26.64%, consumer staples +20.60%, and growth stocks +19.67%.

Key Takeaways

  • Defensive stocks are market leaders, outperforming growth stocks.
  • Strategist Mike Wilson of Morgan Stanley remains bearish.
  • He sees rising risk of recession and stock market declines.
  • Wilson recommends investing defensively.

In particular, Wilson is gloomy about the U.S. economic outlook. "My view remains that the risk in Fed scenarios is weighted towards significantly more cuts because growth is slowing much more than many seem willing to acknowledge, and the risk of a recession has increased materially," he wrote.

If that were not enough, he offers yet another reason for bearishness about the market. "The recent failure of We Company to go public is reminiscent of past corporate events marking important tops in powerful secular trends: United Airlines’ failed LBO in October 1989, which effectively ended the high yield/LBO craze of the 1980s; the AOL/TWX [AOL/Time Warner] merger in January 2000, bringing the Dotcom bubble to a close; JPM’s [JPMorgan Chase's] take-under of Bear Stearns in March 2008, which signalled the end of the financial excesses of the 2000s."

“People are nervous,” Peter Jankovskis, co-chief investment officer at Oakbrook Investments, told Bloomberg. “They see signs of optimism but they’re also wary that these things have broken down several times already. They’re putting their feet back in the water with names they suspect will hold up if these hopes aren’t realized,” he added.

Looking Ahead

In this environment, Morgan Stanley's Wilson says his firm is recommending a long defensive/short secular growth pair "as a way to capture what could be the next move in this cyclical bear market--pricing a recession whether we have one or not."

And a weakening U.S. consumer could put more pressure on the markets. “What we saw in the recent U.S. GDP report was a divergence between the manufacturing side of the economy (still weak) and consumer side (stronger),” Keith Lerner, chief market strategist at SunTrust, told Barron's. However, “the latest tranche of tariffs, if enacted, are much more focused on the consumer,” he said.