Economic News & Analysis—July 25, 2012

Do the times call for "defensive growth"?

By Brian Jacobsen, Ph.D., CFA, CFP®, Chief Portfolio Strategist, and John Manley, CFA, Chief Equity Strategist

The economic data hasn’t been exactly great, but some of it hasn’t been all that bad. I like looking at the Chicago Fed National Activity Index (CFNAI) as a composite indicator of the state of the economy. Although it is pointing to subtrend growth, it is not in recession territory, and it actually marked an improvement from May to June.

Financial conditions haven’t been all that stellar either, evidenced by the historically low yield on the 10-year Treasury and the slow growth of the money supply. However, access to credit is improving, and commercial and industrial lending by banks is picking up. In fact, the Chicago Fed’s indicator of financial conditions, the National Financial Conditions Index (NFCI), is saying that financial conditions are looser than average.

It looks to me that it is more likely than not that economic and financial conditions will continue to improve, albeit at an incredibly slow pace. So, how do you invest in an environment where things could be getting better, but you want to stay defensive in case there are setbacks? I think that’s where you could consider going for “defensive growth.”

Look for defensive growth opportunities in undervalued companies

When other investors are skeptical about the long-term growth outlook, I think it’s time to look for companies whose long-term growth prospects aren’t fully appreciated by the market. To see where those opportunities are, I looked at the index values of various sectors and how they responded to moves in the overall market, changes in economic conditions (measured by the CFNAI), and changes in financial conditions (NFCI). What I was looking for were sectors that moved less than one-for-one with the overall market, which may provide a bit of long-term downside protection. Then, I wanted sectors that would likely move up with the improving economy and financial conditions but not retreat if things don’t improve.

The five sectors I identified that met those criteria were consumer staples, energy, information technology, materials, and utilities. It’s an eclectic mix of sectors that are typically thought of as defensive (consumer staples, energy, and utilities) but with some growth flavor (information technology and materials).

On the fixed-income side, I think short-term high yield makes a lot of sense. Yields, especially relative to Treasuries, are generous. With improving economic and financial conditions, default rates typically fall. Sure, there may not be a lot of room for price appreciation in fixed income, but at least you can get some coupon income.

Instead of feeling like your portfolio is either all-in for growth or all-in for playing defense, why not go for both?

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