Stifel’s chief equity strategist, Barry Bannister, is considering a defensive position in U.S. stocks towards the end of this year. This move comes as a precautionary measure against a potential economic downturn in early 2024. Bannister believes that the labor market is currently “too hot,” and the Federal Reserve may need to take action to combat stubbornly high inflation.

According to Bannister, inflation is unlikely to return to its 2021 lows, which will likely lead to a hawkish stance from the Fed. This, in turn, will limit the upside potential for the S&P 500 in the second half of this year. Bannister’s forecast suggests a rotation from cyclical value to defensive equity groups by the end of 2023, as he foresees an increasing risk of a U.S. recession in early 2024.

Bannister identifies a 4.1% unemployment rate as a signal for an impending recession, which he predicts may occur in December. This implies an economic contraction during the first quarter of next year. In the meantime, Bannister expects the S&P 500 to hover around 4,400 for the remainder of 2023. He also notes that rising real yields will put pressure on growth stocks.

As of Monday afternoon, the S&P 500 was trading at approximately 4,404, above its 200-day and 50-day moving averages. The index experienced a surge of 15.9% during the first half of this year, its strongest performance in the first half since 2019. However, it has dipped slightly in July.

Earlier this year, Bannister predicted a potential rally in the stock market during the first six months of 2023 but expressed concerns about the second half of the year.

In the latter half of 2023, Bannister recommends favoring “cyclical value” over “cyclical growth.” His definition of cyclical value includes sectors such as banks, basic materials, capital goods, transportation, diversified financials, real estate, insurance, and small-cap value stocks. Conversely, he associates cyclical growth primarily with “Big Tech.” Bannister justifies this preference based on his expectation of rising real yields impacting valuations and a slowdown in economic growth without an accompanying recession this year.

Labor Challenges and the Outlook for Inflation

The Federal Reserve is facing challenges in bringing core inflation down to its target rate of 2%, according to experts. Labor conditions are currently too hot, making it difficult to curb inflationary pressures. Economists warn that the Fed may have no choice but to weaken the labor market, potentially leading to an imminent recession signal.

One key indicator to watch is the unemployment rate’s three-month moving average. It is anticipated that by December, the rate could potentially rise to 4.1%, further exacerbating concerns. Cleveland Fed President Loretta Mester also emphasized the need for the central bank to raise interest rates due to inflation expectations surpassing the 2% target for an extended period.

Inflation data for June will be released later this week through the consumer-price-index (CPI). Despite the Fed’s efforts to tame inflation by raising rates since March 2022, the U.S. labor market has remained resilient, maintaining a low unemployment rate.

The Stifel report highlights the sensitivity of different industry groups within the S&P 500 to economic growth and inflation. Analysts suggest a preference for “cyclical value” stocks in the second half of the year. These stocks are expected to perform well when economic conditions improve.

On the other hand, “defensive value” stocks, such as utilities, commercial and professional services, food and beverages, healthcare equipment and services, and energy, are seen as safer options during periods of economic uncertainty.

The report also identifies “defensive growth” equities that include categories like pharma, biotech and life sciences, telecommunication services, consumer services, food and staples retail, and household products.

At the time of writing, the U.S. stock market showed positive momentum. The S&P 500 was up by 0.1%, while the Dow Jones Industrial Average rose by 0.5%, and the technology-heavy Nasdaq Composite edged up by 0.1%.

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