As we head deeper into the third quarter and football creeps into our collective consciousness, investors might also want to think about the Xs and Os of their equity portfolios. In particular, investors may want to explore the merits of getting defensive as growth slows, but not at the expense of upside participation should the U.S. economy execute a soft landing. We believe our dynamic sector allocation and avoidance can offer a balanced approach to addressing the current environment, especially given the elevated risks and potential opportunities we see becoming more evident.

But first, let’s acknowledge and accept where we are today. From our vantage, we see continuing late-cycle economic conditions (past peak growth but not at the trough) in the U.S. Throughout the first half of the year, financial markets were buoyed by narrow pockets of strength—especially mega-cap Technology and Communications Services stocks, particularly those linked to artificial intelligence (AI). Positive investor sentiment was also prevalent and supported the market, in our view, despite signs of a possible broader economic slowdown ahead.

According to the Bureau of Economic Analysis, the annualized growth of real GDP did slow to just 1.4% in the first quarter (the most recent “final” quarterly number available). Even with a rebound to 2.8% in the second quarter this year, GDP remains well below its recent peak of 4.9% in the third quarter of 2023. It appears that contributions to growth from U.S. consumer, fixed investment, and government spending—all key pillars of support—are poised to decelerate. Regardless of what the Fed does later this year, we see few, if any, near-term catalysts for the start of a new cycle in the face of relatively tight monetary conditions and limited slack in the economy.

Although economic growth may grind on through 2024 and into 2025, which warrants selective exposure to economically sensitive sectors, we also believe the late-cycle dynamic of slowing growth alongside investor optimism warrants a judicious degree of caution.

Diagramming some Xs and Os

Considering both the late-cycle economic backdrop and factors that are specific to this cycle, we are allocating to a mix of sectors we believe provide a balance of defensive characteristics, selective economic sensitivity, and positive secular drivers. Interestingly, we believe some sectors currently embody more than one of these characteristics, allowing some of the historically “defensive” sectors to play offense recently—think Utilities in the second quarter, which posted market-like performance and trailed only the Information Technology and Communications Services sectors as the S&P 500 rose in the second quarter.

We do maintain exposure to the U.S. Information Technology and Communication Services sectors, which can add economic sensitivity to portfolios and are benefitting from positive secular trends. However, we are currently underweighting these sectors, due, in part, to our view that valuations and earnings expectations for these sectors tied to the developing AI investment cycle have likely outrun the near-term economic reality of AI. Meanwhile, we continue to avoid the U.S. sectors that we see as most economically cyclical and, thus, most at risk of earnings disappointments late in the cycle, such as Industrials and Materials. 

Health Care is a key sector that we believe provides both attractive defensive characteristics and the potential to benefit from cycle-specific dynamics. The pandemic did a number on Health Care margins, which were depressed in 2023 as COVID-related revenues waned and higher costs flowed through to companies. Looking ahead, we expect margins to recover as wage pressures and the tight labor market cool. Our research shows average hourly earnings for Health Care workers decelerating from peak levels, while labor demand, as measured by the job openings rate, continues to move towards pre-pandemic levels. In fact, we anticipate sector-wide operating margins to rebound above historical averages, which we believe should drive solid earnings growth. This dynamic, combined with the sector’s historically defensive characteristics, make it attractive at this point in the economic cycle, in our view.

Another area of intrigue is Financials, despite our usual characterization of the sector as early-phase. This cycle, we expect (and are starting to see) a rebound in capital markets activity after a sharp pullback over the past two years. In general, Financials could benefit from easing financial conditions, with banks seeing improved net interest margins and capital markets firms seeing an increase in companies refinancing debt and conducting M&A. Moreover, the Financials sector is a more diversified mix of cyclical and secular growth companies today versus recent history, reflecting adjustments to sector definitions and growth of non-bank constituents. Payments companies, which moved from Information Technology to the Financials sector in 2023, have historically shown durable growth, even during economic slowdowns. Additionally, while commercial real estate (CRE) remains a hot-button topic within banking, our research suggests that large banks have considerably less exposure to CRE than smaller, regional banks which, in turn, only make up about 2% of the sector (1/3 of their weight in 2007), making this is a risk that we believe is manageable when looking at the sector as a whole.

Not Just Playing Defense

As you can see, it’s not just about playing defense when growth slows. We see interesting opportunities even when there are lingering concerns for the economy in the near-to-medium term. So, while we encourage some defensive posturing by eschewing industries that tend to perform best early in an economic cycle, we do not think that investors should ignore other compelling upside capture possibilities.  

Philosophically, we believe our dynamic deployment of capital towards and away from certain sectors is an all-weather approach. By identifying and understanding the phases of the economic cycle, and actively shifting allocations as macroeconomic conditions evolve, we seek to help manage risk and provide opportunities for excess returns across our core equity and balanced solutions.

WestEnd Advisors, LLC ("WestEnd"), an SEC-registered investment advisor, operates as an autonomous Victory Capital® Investment Franchise. WestEnd's active principals are responsible for managing the firm and its day-to-day operations. This report should not be relied upon as investment advice or recommendations and is not intended to predict the performance of any investment. The information contained herein is not intended to be an offer to provide investment advisory services.  Such an offer may only be made if accompanied by WestEnd Advisors’ SEC Form ADV Part 2. These opinions may change at any time without prior notice.  All investments carry a certain degree of risk including the possible loss of principal, and an investment should be made with an understanding of the risks involved with owning a particular security or asset class. Portfolio characteristics and/or allocations are generally averages and are for illustrative purposes only and do not reflect the investments of an actual portfolio unless otherwise noted.  Portfolios that are concentrated in a specific sector or industry may be subject to a higher degree of market risk than a portfolio whose investments are more diversified.  While every effort has been made to verify the information contained herein, we make no representation as to its accuracy.