Inflation reached a four-decade high in 2022 and the Federal Reserve responded by raising its benchmark interest rate at its fastest pace since the 1980s. Initially, many experts cried recession as prices soared and credit conditions tightened across the economy. Some have since recanted their forecasts, but others remain convinced of a coming downturn.
Here are the details, along with two index funds that could help investors hedge against a possible recession.
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Some experts still see a recession coming
Steve Hanke, professor of applied economics at Johns Hopkins University, has been ringing the recession bell for over a year. The foundation of his argument is the ongoing contraction in U.S. money supply. He recently said, "We believe that a recession is baked in the cake and will commence during the first half of 2024."
David Rosenberg, president of Rosenberg Research & Associates, also sees a recession on the horizon. His argument centers on the abrupt shift in monetary policy. Rosenberg drew a parallel between the current situation and the recession that ran from July 1981 to November 1982, calling this "the biggest interest rate shock since 1981.".
Hanke and Rosenberg are not alone. Analysts at Deutsche Bank believe a "U.S. recession remains more likely than not" because the Fed has reason to overtighten credit conditions, given the trajectory inflation has followed in the wake of the pandemic.
Defensive stock market sectors outperform during recessions
The National Bureau of Economic Research (NBER) is a non-profit group widely recognized as the authority on business cycles and recessions. When economists talk about business cycles, they're referring to alternating periods of economic expansion and contraction as measured by changes in income, spending, employment, and industrial production.
The NBER defines a recession as a period of economic contraction that begins when the business cycle peaks and ends when the business cycle troughs. But economists generally break the expansionary period into three phases: the early cycle recovery, the mid-cycle expansion, and the late-cycle slowdown.
Certain stock market sectors tend to perform better in different phases of the business cycle. Detailed below are the three sectors that have historically performed best during each phase, according to State Street Global Advisors:
- Early-cycle recovery: consumer discretionary, real estate, materials
- Mid-cycle expansion: financials, technology, communications services
- Late-cycle slowdown: consumer staples, healthcare, industrials
- Recession: consumer staples, utilities, healthcare
Consumer staples and healthcare are generally viewed as defensive sectors. Stocks in those sectors tend to perform well during late-cycle slowdowns and recessions, and that makes sense on an intuitive level. Products in the consumer staples and healthcare categories are some of the very last things consumers would forgo in a difficult economic environment.
For that reason, investors worried about a possible recession should consider buying two index funds: the Vanguard Health Care ETF (VHT 0.03%) and the Vanguard Consumer Staples ETF (VDC -0.17%).
1. The Vanguard Health Care ETF
The Vanguard Health Care ETF tracks 415 U.S. stocks that generally fall into two categories: (1) companies that manufacture healthcare equipment or provide healthcare services, and (2) companies involved in pharmaceutical and biotechnology research.
The top five holdings in the index fund are detailed below:
- Eli Lilly: 7.8%
- UnitedHealth Group: 6.8%
- Merck: 4.8%
- AbbVie: 4.5%
- Thermo Fisher Scientific: 3.8%
The Vanguard Health Care ETF returned 197% over the last decade, or 11.5% annually. That falls just short of the 210% return in the broader S&P 500, but the index fund was also less volatile than the S&P 500 during that time period, as evidenced by its 10-year beta of 0.77.
The Vanguard Health Care ETF bears a below-average expense ratio of 0.1%, meaning the annual fee on a $10,000 portfolio would be just $10. For context, the average index fund expense ratio was 0.37% in 2022, according to Morningstar.
2. The Vanguard Consumer Staples ETF
The Vanguard Consumer Staples ETF tracks 105 U.S. stocks in the consumer staples sector, including manufacturers, distributors, and retailers of various food, beverage, and tobacco products.
The top five holdings in the index fund are detailed below:
- Procter & Gamble: 12.6%
- Coca-Cola: 8.2%
- PepsiCo: 8.2%
- Costco Wholesale: 8.2%
- Walmart: 8%
The Vanguard Consumer Staples ETF returned 130% over the last decade, or 8.7% annually. That represents significant underperformance, compared to the 210% return in the broader S&P 500. However, the index fund was also far less volatile during that time period, as evidenced by its 10-year beta of 0.62.
The Vanguard Consumer Staples ETF bears a below-average expense ratio of 0.1%, so investors would pay just $10 per year on a $10,000 portfolio.
Investors should keep recession fears in context
The Vanguard Health Care ETF and the Vanguard Consumer Staples ETF are good options for risk-averse investors who want to hedge against a possible recession. But investors need to keep their fears in perspective. The S&P 500 has weathered dozens of recessions over the decades and has always recovered.
The Vanguard Health Care ETF and the Vanguard Consumer Staples ETF are proven moneymakers, but the S&P 500 has outperformed both index funds over the last decade. For that reason, investors who can tolerate some volatility should keep most of their money in an S&P 500 index fund and/or individual stocks.
