Despite the buzz of artificial intelligence (AI) and the continued excitement surrounding chip stocks like Nvidia, the S&P 500’s push to new heights isn’t being led by stocks in the technology sector anymore. Surprisingly, it’s defensive industries that are hot.
Among the top 11 industry sectors that make up the S&P 500, defensive oriented groups like the Utilities Select Sector SPDR Fund (XLU), Consumer Staples Sector SPDR Fund (XLP) and Health Care Sector SPDR Fund (XLV) are leading the way.
With a year-to-date gain of 21.83%, XLU is the top performing industry sector within the S&P 500 as of August 26. Just behind it are XLP with a 16.14% gain and XLV with 14.78% increase.*
The expectation of cuts in U.S. interest rates starting in September has contributed to the rise in utilities.
Utilities companies typically carry high levels of debt due to the significant capital expenditures required to build and maintain infrastructure. When interest rates rise, the cost of servicing this debt increases, potentially squeezing profit margins. The opposite is true is true as interest rates decrease with borrowing costs following suit.
Dividends are another big factor that weighs in favor of utilities. With SPY’s current dividend yield of just 1.22%, XLU’s yield of 2.89% is more than double that of the S&P 500. Also, many dividend-focused investors prefer the boring utilities sector for its relatively stable dividends, which are sometimes viewed as an alternative to bonds.
Another view of expected U.S. interest rate cuts is that a slowing economy will lead to tapering inflation.
Decelerating economic activity is less impactful on consumer staples stocks held inside the previously mentioned fund, XLP. Stocks held inside the fund represent companies that produce or sell essential products, including food, beverages, household goods, and personal care products. These stocks are generally considered defensive because they tend to perform relatively well during economic downturns, as demand for these essential goods remains stable.
Coca-Cola, Costco Wholesale and Philip Morris International are among XLP’s top holdings. These companies are integral to everyday life, making their stocks popular choices for investors looking for stable returns and less volatility, especially in uncertain economic times.
Finally, healthcare stocks inside XLV could be positioned well for a softening economy. Healthcare services and products, such as medical treatments, hospital services, and pharmaceuticals, are non-cyclical and non-discretionary. Demand for these services generally remains constant regardless of economic conditions, making the sector less volatile to economic downturns.
In 2020, XLV gained 13.14% while many other industries collapsed during the Covid-19 outbreak. And during the 2022 bear market in stocks, the healthcare sector proved its resilience. While the broader S&P 500 fell over 18%, XLV declined by a modest 2%.
Historically, healthcare stocks have shown strength during recessions. People prioritize health-related spending, even when they cut back on other non-essential expenditures.
As advisors navigate changes to the economic landscape, defensive sector ETFs can be used for tactical asset allocation.
Adjusting a client’s exposure to different industry sectors based on market conditions, economic cycles, or sector-specific trends can help smoothen volatility. It can also help to increase dividend cash flow and help manage equity risk.
Ron DeLegge II is the founder of ETFguide.com and author of several books, including "Habits of the Investing Greats" and "Portfolio Architecture: A Handbook for Investors."