The economic resilience in the face of an aggressive Fed rate-hiking cycle began to show widening cracks in the second quarter. Investors concerned about economic slowing, stagflation, or recession can find defensive opportunities across a variety of strategies.
2023 brought a year of volatility but also economic strength despite soaring interest rates. Recession odds were pushed back and then back again as consumer spending, a strong labor market, and mega-cap outperformance buoyed growth.
“Morgan Stanley’s intermediate-term outlook has dimmed, however, with odds of a recessionary ‘hard landing’ or ‘stagflation’ rising to 25%-30%,” Lisa Shalett, CIO, Wealth Management at Morgan Stanley wrote last month.
The ISM Manufacturing Index indicated contraction in May, while private payrolls slowed more than expected last month. These signals alongside consumer spending pullbacks could spell trouble for the economy.
Investing for Near-Term Rate Uncertainty
While economic indicators signal slowing across several fronts, the Federal Reserve proved nearly impossible for markets to accurately predict in the current rate cycle. Should the Fed hold rates when markets expect cuts, volatility could potentially spike. Ultra-short-duration bonds remain a favorite defensive play in ongoing market volatility and economic uncertainty.
Investors wanting to wait out near-term rate uncertainty alongside economic slowing should consider the Eaton Vance Ultra-Short Income ETF (EVSB). The fund offers exposure to a diversified mix of investment-grade bonds. These include short-term fixed, variable, and floating-rate bonds across a variety of sectors. The portfolio is actively managed with a collective duration of one year or less (currently 0.53 years as of 6/03/24).
EVSB also offers noteworthy yields for income investors. The fund currently has a 30-day subsidized SEC yield of 5.67% as of 6/03/24. The fund has an expense ratio of 0.17%.
See also: “Morgan Stanley Fixed Income Outlook: Look to Intermediate Duration“
Hedge Against Economic Drawdown in Munis
Periods of recession and economic drawdown are often accompanied by stock declines. As a broad category, bonds often generate less volatility in recessions, though some may prove more stable than others.
Governments bonds historically prove popular with investors in times of recession and economic drawdown. These bonds are often valued for their stability and low default risk. The Eaton Vance Intermediate Municipal Income ETF (EVIM) offers bond diversification alongside tax benefits. The fund is actively managed and invests across states, credit tiers, and municipal sectors.
Income earned from municipal bonds generally qualifies as exempt from federal income taxes. Municipal bonds also offer potential state tax exemptions, depending on the state of issuance as well as where investors file taxes.
It’s a fund to consider for investors looking to diversify their bond holdings, add tax-beneficial income, or increase duration should rates decline. EVIM currently offers an average duration of 6.12 years as of 6/03/24. The fund carries an expense ratio of 0.29%.
Defensive Positioning Within Equities
Investors concerned about the impact of volatility and potential drawdowns within equities should consider the Parametric Hedged Equity ETF (PHEQ). The fund combines equity exposure with an options overlay strategy to mitigate potential losses.
PHEQ invests in U.S. large-cap stocks within the Solactive GBS US 500 Index while using options to hedge against drawdowns. The strategy optimizes the weights of its holdings to create a risk-and-return profile similar to that of the Index.
It also employs a laddered options overlay strategy. This sacrifices some upside potential for downside protection. PHEQ does so by using a put-spread collar strategy wherein it buys close-to-the-money protective puts and sells further-out-of-the-money puts. Any loss mitigation is limited to that which the put-spread covers. The fund also writes calls, thereby earning a premium to offset the put spreads. PHEQ carries an expense ratio of 0.29%.
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