Stock Market Playbook: What to Invest in As Recession Risks Rise

Wall Street thinks the risk of a recession is growing, and according to Morgan Stanley’s top stock strategist, there are a few moves investors can make to position for an economic slowdown.

Mike Wilson, the chief investment officer at the bank, said he believes the risk of recession had gone up to around 30%-35%, up from 10%-20% at the start of the year. That’s weighing on the outlook for stocks, he said, adding that the S&P 500 could drop below 5,500 in event of a hard landing.

“Once again, I think a majority of strategists and clients came into the year probably too bullish about kind of the trajectory,” Wilson said speaking to Bloomberg on Thursday. The bank’s base case though, is that the S&P 500 will rise to 6,500 over the next 12 months, which implies the benchmark index rising 14% from current levels.

Talk of a potential recession has been growing louder on Wall Street. Earlier this month, Goldman Sachs raised its probability of a recession over the next 12 months from 15% to 20%. Meanwhile, a March survey conducted by Bank of America found that 55% of fund managers said they saw a global recession triggered by trade war as the top risk to the market.

Wilson said that the bank had been positioning for economic weakness over the last year, which is one reason Morgan Stanley’s Focus List, a list of the bank’s top investment ideas, has outperformed the S&P 500. The list has returned 7% year-to-date, compared to the benchmark index’s 3% loss.

“We’re just being more tactical, I think, than most people,” he added. “So we’ve been in the right sectors; we’ve been in the right tractors, for the most part, really for the last year.”

He highlighted several moves he and his team were making amid the current economy.

1. Shift away from consumer goods

Morgan Stanley has shifted away from consumer goods stocks. That’s due to underlying weakness in the economy, Wilson said, adding that he believed most of the “private economy” had already been in a recession for at least two years.

He pointed to the drop in home sales and manufacturing activity, which first began to decline several years ago.

“We’ve been, you know, underweight consumer goods for literally three years and it’s paid every year,” he added.

Concerns about consumer spending have been on the rise recently.

Consumer confidence declined for the fourth straight month in March, with consumers’ expectations for income, business activity, and the job market falling to the lowest level in 12 years, according to the Conference Board’s latest survey.

Household finances also look weaker, with fewer Americans able to cover emergency expenses than they were several years ago. According to the latest Survey of Consumer Expectations from the New York Fed, 63% of US households said they had enough cash on hand to cover a surprise $2,000 bill, the lowest proportion recorded since 2015, according to an analysis from Apollo Global Management.

2. Shift away from small caps

For similar reasons, Wilson’s team has also shifted away from small-cap stocks.

The Russell 2000 is down 7% so far this year.

“Small cap stocks, it’s paid every year to be underweight these areas,” Wilson said. “So the market gets the joke. I just think a lot of stock observers haven’t really understood what’s been going on here. You know, the economy has not been strong. It has not been a balanced, good economy.”

3. Buy quality defensives and quality growth stocks

Morgan Stanley’s core portfolio is made up of high-quality companies in the defensive and growth sectors, Wilson said.

That’s because, in the current economic climate, companies don’t have pricing power. That differs from several years ago when inflation accelerated and companies were able to raise prices to boost profits, he said.

“Today it’s the exact opposite. Companies don’t have pricing power, They can’t really pass this on. So we’ve had a margin squeeze really in a lot of industries over the last couple of years, except for, if you’re a monopoly,” he added, pointing to large tech firms and other businesses that have been able to operate efficiently.

“So that market is still very much intact,” Wilson said.

4. Wait to purchase the weakest sectors and companies

Investors should have their eye on the market’s laggards — and be ready to jump on them when the economy officially enters a recession, Wilson said.

“If you have a true hard landing, the day that it becomes consensus, the first thing you want to do is buy the lowest quality stuff on the market,” he said. You want to buy beaten up, you know, really levered companies, you know, bad balance sheet type businesses.”

He pointed to consumer goods, materials, and the energy sector in particular, all of which could benefit as the economy enters a “rolling recovery” and which need fresh economic growth to reset and move higher, he said.