With the S&P 500 rising more than 20% from its lows in October 2022, the benchmark index is now officially in a bull market. But according to Barry Knapp, managing partner at Ironsides Macroeconomics, danger could be looming in the distance.
The macro expert is concerned about a recession.
“The probability of a recession is much higher in mid-2023 than it was in 1994,” Knapp said in a recent CNBC interview.
Knapp drew the comparison with 1994 because that’s when the Federal Reserve had another aggressive tightening cycle. Rate hikes can slow the economy, but this time, there’s something else that the U.S. has to deal with.
“Because of the fact that the yield curve is 100 basis points inverted, the banking system is in a much more tenuous situation,” he said.
Yield curve inversion refers to the phenomenon that short-term bonds have a higher yield than longer-term bonds. It reflects that investors are more pessimistic about the long term — they expect that in the future, the Fed will need to lower interest rates to stimulate the economy.
An inverted yield curve is considered to be one of the more reliable leading indicators of a recession. But an economic downturn may not be the only thing investors have to prepare for. Knapp also pointed out another issue — liquidity.
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Liquidity Shock And Risk-Off
The U.S. debt ceiling has been raised again. While that means the country has avoided defaulting on its debt, it could impact liquidity in the financial markets.
“One of my core themes for the first half of the year was until we got a debt ceiling deal, we were going to have plenty of liquidity in the system. But once that debt deal got done, then we were going to have what I’m calling another extreme liquidity climate change storm,” Knapp said.
The reason is that now that the borrowing limit has been increased, the government will issue new Treasury securities to finance its operations. And that will attract investors who seek the safety and stability offered by these government bonds. Meanwhile, an influx of funds into Treasury securities could lead to less available funds for other investments, including stocks.
“I think we are due for one of these storms because of all this issuance that we get, we will probably have a risk-off episode,” Knapp said.
In a risk-off scenario, investors tend to sell riskier assets like stocks and put money into less risky assets like government bonds.
It’s a scary picture for stock market investors. But that doesn’t mean you should ditch your stock portfolio completely.
3 Defensive Moves
Given this macroeconomic backdrop, Knapp outlined three things investors can do right now.
“We are about to have a liquidity shock, so things like buying equal weight, selling the cap weight S&P, lightening up your tech exposure, I think you’ll want to be doing those things because we have a storm coming,” he said.
Buying equal weight: Knapp suggests buying the equal-weight S&P 500, which gives each company in the index an equal weight. This means the performance of each individual company has the same influence on the overall index value. Investors who want to track the equal-weight S&P 500 can look into exchange-traded funds (ETFs) like the Invesco S&P 500 Equal Weight ETF RSP.
Selling cap weight: The standard S&P 500 Index is market cap weighted, so larger companies with higher market capitalizations have a greater impact on the index’s performance. Knapp suggests selling this index.
Reduce tech exposure: Tech stocks have made a strong comeback in 2023, partially fueled by investor enthusiasm toward artificial intelligence (AI). But Knapp is erring on the side of caution, warning that “we could take a lot of the froth out of AI stocks.”
The Bottom Line
Knapp said that the market-cap-weighted S&P 500 could fall, but he doesn’t believe the equal-weighted S&P 500 “will go down very much at all.”
The projection is no surprise given his third move of lightening up on tech. The market cap weighted S&P 500 is heavily weighted toward the tech sector because tech giants command huge market caps. Therefore, moving from market-cap-weighted S&P 500 to an equal-weighted index is a way of reducing exposure to tech.
Stocks are volatile and no one can predict the future with certainty. If you don’t like the stock market’s wild swings, you might want to look into reliable income plays outside the stock market.
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