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By Kevin Michael O'Brien, Gavin Nichols, and Katarina Jerinic
In the looming recession, investors should look towards a low-beta ETF that has shown a predictable performance during a recession. Consumer Staples Select Sector SPDR ETF (XLP) has proven stability through the 2001 and 2008 recession. When compared to the S&P 500, the returns from XLP are better during a recession and the recovery period following a recession is much shorter. The Fed's decision against increasing interest rates also follows previous patterns. Following the notion of zero interest rates hike this year will only accelerate a recession.
Meanwhile, worldwide negotiations - including Brexit and the trade war in China - will heavily impact the economy. The Brexit deadline is 3/29/2019 and there is no real plan of action. The tariff negotiations with China have stalled and continue to increase the trade deficit.
With the Fed being patient during a time of so much global economic uncertainty, it is recommended to invest in a safe ETF like XLP, which has proven to keep up with a fragile economy.
Last Leg of the Bull Market
Enjoy this final run of the bull market. On Aug. 22, 2018, the current bull market had become the longest in U.S. history. Towards the end of last year, the Dow hit 26,828.39 in October followed by a low of 21792.2 on Christmas Eve. Santa brought a lump of coal on Christmas and expect Santa to bring even more coal next Christmas. Investors need to start looking to safe guard their investments as a 2020 recession is likely to occur 12-18 months from now.
Even though the Dow has gone from 21792.2 on December 24th to 25450.24 on March 8th, 2019 - there has been a slowdown in the economy. The GDP growth rate missed expectations of 3% in 2018. Now, economists point to smaller GDP growth in 2019.
Many consumers and small businesses are starting to develop uncertainty about how successful 2019 will be. U.S. retail sales fell 1.2% in December which has raised uncertainty into how strong the economy is among small business owners. President Trump's efforts to try and strike a new trade deal with China or heavily increase tariffs has less ground to stand on given the new retail sales and uncertainty of small business owners. Small businesses will only get a small lifeline if the tariffs affecting their industries can be reduced. For the trade deficit to reach the same levels that it was in 2016, U.S exports need to increase 63.4% from their 2018 levels.
Consumer Staples Select Sector SDPR ETF
Investors should start shifting their investments into XLP, a low-beta ETF. XLP is an ETF that has holdings in the consumer staples sector. XLP has proven itself in past recessions for being defensive and having a quick recovery time which can be applied to future recessions. A few of the holdings in the ETF are Procter & Gamble (PG), Coca Cola (KO), Walmart (WMT), and Pepsico (PEP). These four companies alone are all strong securities in an economic downturn.
Another specific benefit to XLP is its weight distribution across its holdings. According to Kiplinger: "And because XLP is a market-capitalization-weighted fund - where larger companies comprise more of the ETF's under management - it's top-heavy…" The benefit of this is an all-around safer ETF given the fact that the majority of the ETF is comprised of companies like Procter & Gamble, Coca Cola, Walmart, and Pepsico. Kiplinger also mentions that XLP has a yield of 2.8%, which is among the best in the SPDR funds.
XLP vs. S&P 500
In the graph above, it is showing a comparison between XLP in green and the S&P 500 (SPX) index in white. The graph shows both the early 2000's recession and the 2007-2008 recession which are shaded in red. When looking at the early 2000's recession, XLP faced negative returns of only -1.48% while SPX faced negative returns of -9.21%. This is a drastic difference and displays the defensiveness of XLP.
The arches at the bottom of the graph display the amount of days it took for XLP and SPX to recoup their losses from the start of the recession. In the 2000 recession, XLP took only 260 days compared to the 1,111 days it took SPX. The recouping times and returns show the defensiveness and solidarity of XLP compared to SPX during and after a recession.
The Great Financial Crisis of 2007-08 displays a very similar story. XLP dropped -20.94% compared to SPX which dropped -38.75%. Time to recoup on losses were 737 days for XLP and 1291 days for SPX for this recession. Overall, The data clearly shows that during a recession, XLP is able to hold its value compared to the overall market. In addition, the time to recoup losses will likely be much less than the overall market.
Given all of this information, XLP is a safe investment during recession because of its low beta and collection of holdings. Among this, it has proven itself in past recessions to perform better than the market. While a recession will not prove to be good for anyone, it's better to have a stable investment that's steady and resilient.
The Fed and Interest Rates
The Fed has decided to step back from another interest rate hike. Looking at previous recessions and when the Fed decided against increasing interest rates, a recession occurred 15-18 months after the final rate hike.
Fed Interest Rate Pauses
If we look at the time the Fed stopped raising rates in the previous two recessions, we see that the time it takes from the last hike until the start of the recession is 15 months in 2000-01 and 18 months in 2006-07.
In 2000, the last interest rate hike was May 16, 2000, and the recession began March 1, 2001. During the Great Financial Crisis, the final interest rate hike was on June 29, 2006, followed by the start of the recession on Dec. 1, 2007. Given the current conditions today, if the Fed decides not to raise interest rates, this would put a recession in the timeline of March 2020 - August 2020.
The chart also shows the 10-year treasury yield minus the 2-year treasury yield. One of the leading indicators of an upcoming recession is when the 2-year treasury yield is higher than the 10-year treasury yield causing an inversion. We see these inversions (in red) in 2000 and in 2006-2007. The yield curve is now flattening which indicates economic slowdown and uncertainty. Many of the catalysts weighing on the economy could play a significant factor in accelerating a yield curve inversion. Some of those catalysts being - the large drop in retail sales, increasing trade deficit, and decrease in consumer confidence. We should see the GDP growth projections decrease moving forward which will not bode well with investors and the global economy.
Currently, the uncertainty revolving around March Madness includes the pending decision of the United Kingdom leaving the European Union as well as the little progress in regards to trade with China. Moving forward with the current plan to raise tariffs on China, it could have negative effects on the U.S. economy in the short run and long run.
It could first affect small businesses, which are a large job supplier for Americans. Looking at how small businesses operate prior to a recession, they tend to slow down on investments as well as become more passive. Currently 36% of small businesses are pessimistic about their own businesses' prosperity.
With the prices rising from manufacturers, many businesses are forced to increase prices to make ends meet. This has caused strain on many small businesses because the rising prices of their products are pushing customers away. On the other side, small businesses that are not raising prices are dealt with lower margins and reduced profits. With small businesses becoming more pessimistic towards 2019 and the trade war with China uncertain, investors need to make sure they safeguard their investments for an economic downturn.
As investors look towards the future, it is important to keep in mind that we have been in the longest bull market in U.S. history. This very well could lead to the quickest bear market and into a recession in U.S. history. While keeping an eye on the important milestones over the next couple of months in regards to Brexit, trade war with China, the Fed interest rates, and global economies - investors should start shifting investments into XLP. This will ensure that when the pullback occurs and the recession strikes, your investments will be safeguarded against risks.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.