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The Tell: Why this Morgan Stanley portfolio manager is ‘gradually’ getting less defensive in stocks as recession fears rise

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It may be time to get a little less defensive and shift toward buying some crushed stocks as recession fears intensify, according to Andrew Slimmon, an equity portfolio manager at Morgan Stanley Investment Management.

“We are gradually reducing our defensive exposure, and we are gradually buying some of these consumer discretionary stocks that are down” 50% or 60%, Slimmon said by phone. He said that he’s also “gradually” trimming energy exposure after the sector’s strong gains this year. 

A defensive position heading into 2022, with “heavy exposure” to areas such as staples, utilities and healthcare, has worked relatively well in this year’s slump, said Slimmon. But once a market view emerges that the Federal Reserve is mostly through raising interest rates in its effort to battle inflation, “that positioning is not going to work.”

In Slimmon’s view, the market will bottom when investors think inflation has peaked and the Fed is mostly done hiking its benchmark rate. Last week, San Francisco Federal Reserve President Mary Daly signaled her support for another big rate increase in July to help curb the surge in the cost of living in the U.S.

The S&P 500
SPX,
-0.27%

plunged 20.6% in the first six months of 2022, its worst first half performance since 1970, according to Dow Jones Market Data. It’s been a brutal year for the other major stock benchmarks, as well.

The Dow Jones Industrial Average
DJIA,
-0.27%

finished the second quarter with the largest quarterly percentage decline since the first three months of 2020, while the Nasdaq Composite
COMP,
-0.44%

suffered its biggest quarterly decline since the fourth quarter of 2008, according to Dow Jones Market Data.

“We’re just not through the downside of this yet,” he said. “I think we’re getting close.”

Read: ETFs inflows take steep drop in first half of 2022, high-yield bonds see ‘massive’ outflows amid recession fears

U.S. stocks were trading modestly lower in early afternoon Friday, with the S&P 500 down 0.1%, the Dow falling around 0.2% and the Nasdaq off about 0.3%, according to FactSet data, at last check. 

“Areas that have been clobbered, like consumer discretionary stocks,” will at some point see a “huge recovery,” Slimmon said. 

The S&P 500’s consumer discretionary sector
SP500.25,
+0.83%

plummeted 33.1% in the first half of this year, according to FactSet data. Stocks with “anything to do with homes” have been hard hit, said Slimmon, pointing to homebuilders, home retailers, home furnishings and home appliances.

That’s partly because people made a lot of home-related purchases earlier in the pandemic, and they’re now spending their money on travel instead, according to Slimmon. Plus, mortgage rates are going up, making it more difficult to purchase homes. It’s “a triple whammy of bad news,” he said.

Shares of the SPDR S&P Homebuilders ETF
XHB,
+2.14%

dropped 36.2% in the first half of 2022, FactSet data show.

Weakness is the stock market has rotated from concerns about price-to-earnings ratios being too high in the face of rising rates, to worries that the U.S. may be in or nearing a recession, according to Slimmon. Investors now worry that stocks are vulnerable to company earnings estimates being revised lower, he said. 

The Federal Reserve Bank of Atlanta’s “GDPNow” tracker estimates that the U.S. economy shrank 1% in the second quarter, according to a June 30 report from the Atlanta Fed

But Slimmon expects that a recession would be “short and shallow,” citing strong corporate balance sheets. If that’s the case, he said, then it’s time to consider which stocks to buy that stand to participate “more in the upside.”

It’s very hard to pick a bottom with stocks beaten down so much, but when they turn, “they can go up a lot,” he said. By contrast, he’s wary of demand destruction in the energy sector, which ended the first half of this year with double digit gains.

The S&P 500’s energy sector
SP500.10,
-0.11%

rose 29.2% in the first six months of 2022, according to FactSet data.

“The time to buy energy was a year and a half ago,” said Slimmon. “I own energy stocks, but we’re trimming into strength.”

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