Prevent Equity Portfolio Capital Erosion From An Economic Slowdown

Includes: JNJ, VDC, VHT
by: Disruptive Investor

The U.S. economy has shown surprising resilience amidst a sharp slowdown in the emerging markets and a recession in the eurozone. In particular, U.S. GDP growth, which was moving very much in tandem with eurozone economic growth, has shown divergence in the last few quarters. U.S. real GDP growth is still over 2% with eurozone slipping into recession.

Will the divergence stay and U.S. growth sustain?

This article looks into some of the key factors which can kill growth in the U.S. over the next few quarters. In line with the expectation of slower growth, an investment strategy for the near-term is discussed.

Moderate inflation might be one of the key agendas for the Fed. However, inflation is a dynamic process and a sudden rise in inflation can negatively impact consumer spending and lead to muted economic growth. One of the primary reasons for believing that U.S. economic growth might slump in the foreseeable future is the trend in gasoline and food prices. The charts below give the retail gasoline and retail food prices in the U.S. As the first chart shows, retail gasoline prices have moved up sharply in the last month.

According to the Commerce Department, consumer spending rose 0.5% in August from July 2012. The rise in consumer spending was the biggest since February 2012. However, excluding the impact of higher gas prices and other price gains, the growth in spending was just 0.1%. Further, food prices have also shown an increasing trend in the recent past as evident from the chart. Retail food prices are also expected to trend higher in the foreseeable future.

Rising prices of necessities such as food and fuel will impact spending elsewhere as the disposable income shrinks on the back of inflationary pressure. To add to the concerns, personal disposable income grew by only 0.1% in August. However, income declined by 0.3% when adjusted for inflation. Clearly, these are not great signs at a time when the global economy is already in a manufacturing recession.

I personally expect consumer spending to weaken in the foreseeable future when adjusted for inflation. If banks don't increase lending and consumers avoid further leverage, there will be no benefit derived for the real economy from QE3. I don't see bank lending surging in the medium-term. In line with this expectation, there are slim chances of QE3 doing any good to the real economy over the next few quarters.

Coming to the key question of the probability of recession, the Treasury spreads don't suggest recession in the foreseeable future.

However, it might not take long for this to change with the issue of fiscal cliff and another debt ceiling debate in the queue. Further, the eurozone recession and a sharp slowdown in China will add to the downside pressure on growth. Under these circumstances, one needs to tread with caution. This is especially true for equity markets, which is trading at multi-year highs.

I discussed my bullish view on equity markets in the long-term in one of my earlier articles. I do maintain my long-term view. At the same time, I would remain cautious when it comes to taking new positions in the market over the next few months. On the contrary, I would lighten up my equity position or move into relatively defensive sectors, which might not be impacted meaningfully by a recession. It is also a good idea to be in cash (to some extent) as a correction for equities would mean a bull market for cash.

For exposure to the relatively defensive stocks, I would consider the following ETFs:

The Vanguard Consumer Staples ETF (NYSEARCA:VDC) - The ETF seeks to track the performance of a benchmark index that measures the investment return of stocks in the consumer staples sector. The ETF also has a low expense ratio of 0.19%. In terms of sub sector exposure within the consumer staples sector, the ETF has 19% exposure to the household segment, an 18.1% exposure to soft drinks segment, a 16.6% exposure to the packaged foods & meats segment, and a 16.4% exposure to the tobacco segment.

The Vanguard Health Care ETF (NYSEARCA:VHT) - The ETF seeks to track the performance of a benchmark index that measures the investment return of stocks in the healthcare sector. I have been mentioning the expense ratio as it is comparatively lower compared to other ETFs. The ETF also has an expense ratio of 0.19%. In terms of sub sector exposure within the healthcare sector, the ETF has 45% exposure to the pharmaceuticals segment, a 15.8% exposure to the biotechnology segment, a 14.7% exposure to the healthcare equipment segment, and a 7.5% exposure to managed healthcare.

In terms of specific stocks, Johnson & Johnson might be a good buy in the defensive stock category.

Johnson & Johnson (NYSE:JNJ) - I like the highly diversified healthcare company with a product as well as regional diversification. Further, the sector catered to by JNJ is not very prone to economic shocks. JNJ has been a good dividend payer in the past with a dividend yield of 3.5%. It also commands a higher rating than the U.S. Sovereign Rating. Further, JNJ has a low beta of 0.49, which is ideal for investors expecting correction and increased volatility in the markets.

Disclosure: I 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.