Stay strong, but defensive

It's been painful, but we believe the risk-reward on stocks is lurching into balance. The economic outlook has grown more sober-this week, our macroeconomic policy team cut its forecast for the third time this year (more below)-with recession and stagflation headlines dominating the business press. That said, the market has been aggressively pricing in many fears, creating the potential for a near-term bottom. We don't think we're there yet, which is why we continue to favor the defensive positioning we put in place nine months ago and have added to since, with overweights in particular to large-cap dividend and cyclical value stocks and to cash. Here are four themes behind our thinking:

1. We expect real to slow to 2.4% this year (our initial forecast was 3.9% at the start of the year) and an even slower 1.5% in 2023. With inflation soaring, earnings reports of late point to a consumer who is beginning to resist price increases, and to companies, especially intermediaries such as retailers, increasingly forced to accept margin compression to maintain market share. Tech companies, realizing they have over-extrapolated Covid-era demand and as a result have over-expanded, are now announcing cutbacks in hiring. Fed hikes also are raising borrowing costs for home buyers and for corporations trying to finance inventories. All of this together is already slowing economic growth.
2. Although we have cut our numbers, we are not yet forecasting a full-blown recession.Inventories generally are tight across the economy and given the huge gap between job openings and job applicants, there is a lot of room for more hiring slowdowns to come before actually leading to outright job losses and depressed consumption. And the banking system is in good shape to handle the road bumps that may lie ahead on the credit side.
3. More importantly, whether a mild recession or just a growth slowdown, we don't see a dramatic pullback in nominal profits.Because inflation is likely to prove sticky in certain areas, especially commodities and rents, nominal , even in a 1% real environment, could be mid-single digits. For many companies, that will translate into mid-to-high single-digit revenue growth. Even if their margins compress somewhat, nominal earnings could well be stable to down only modestly before re-accelerating in late 2023. In the past, we've had periods of low real economic growth and an "earnings recession." This time around could prove the opposite: low nominal earnings growth against a recession in real, but not nominal, .
4. We think the market overall is closing in on a bottom and has almost priced in a mild recession and/or "rocky landing." We think that "rocky" level could be 3,500 on the 500, which is only 10-12% away. On an individual stock level, we'd note that many of the more cyclical names, such as the banks, already at those comparable levels, in our view. This said, there are still large elements of the market which, in our view, remain overvalued against a backdrop of perhaps permanently higher bond yields. This-plus concerns that the rocky landing could become a hard landing should the Fed overdo it-is likely to make calling a market bottom dangerous.

Bottom line: remain defensive and be ready to start averaging into more aggressive stocks (either cyclicals or growth stocks, depending on levels) at an under 3,800. Given our view that there is downside to 3,500, and the large number of dip buyers at the 3,850 level that has held twice on an intra-day basis in the last two weeks, we are not sure we'll reach 3,500. But there are plenty of icebergs out there that we could crash into that could lead to another move lower. So, with upside limited until the outlook becomes clearer later in the year, we think for now the best course is to remain defensive. Within that realm, we like large-cap dividend stocks in consumer staples, energy, Big Pharma and utilities and among cyclicals, we think banks are well positioned. We also like cash and recommend underweighting bonds.