Wall Street veterans offer 3 trading strategies for investors worried about a recession

Talk of a recession is heating up, with Wall Street veterans flagging the rising risks of a downturn — and offering advice on how to invest during this cycle.

Investment bank Morgan Stanley said that while a recession isn’t its base case, it is its bear case because the risk of one has “gone up materially.”

“Needless to say there are numerous shocks hitting the economy right now that could tip us over into a recession at some point in the next 12 months,” said the investment bank in a May report. It cited factors such as an escalation of the Russia-Ukraine war that may push oil prices to $150, the extremely strong dollar, and crushing cost pressures on companies.

Wall Street veteran Ed Yardeni, who had said in April there was a 30% chance of a recession, last week raised that figure to 40%, while Citi CEO Jane Fraser told CNBC she was convinced that Europe is headed for a recession.

The war in Ukraine has caused energy prices to spike and food prices to rise. The U.S. and U.K. — and other countries around the world — are grappling with inflation that has risen to multi-year highs.

Major stock indexes have posted steep declines since peaking late in 2021 and early this year, with the Nasdaq losing around 23% since the beginning of 2022. The S&P 500 has dropped about 13% in the same period.

Here’s how antsy investors can ride out persistent turbulence in the stock market, according to the experts.

As volatility is set to stick around, Morgan Stanley recommended defensive sectors in a May 16 report on its U.S. stock outlook. Those include health care, utilities and real estate.

“With the exception of Energy, all of the top performing sectors have come from the defensive end of the spectrum,” Morgan Stanley wrote. “We do not believe defensives will have a great run of absolute performance but they should offer some relative protection as our call for lower earnings and multiples would hit cyclicals harder.”

Defensive stocks provide stable dividends and earnings regardless of the state of the overall stock market, while cyclicals are stocks that can be affected by the cycle of the economy.

This is what Morgan Stanley says about the three defensive sectors:

• Health care: The sector is trading at a discount to the overall market, unlike most other defensive sectors, according to Morgan Stanley. The bank prefers large-cap stocks in pharmaceuticals and biotech, adding that they are trading at an attractive price and offers relatively attractive dividend yields.

• Real estate: The sector gained 42% last year, and has outperformed the broader U.S. market by 16%, said Morgan Stanley. The bank likes this sector for its earnings stability and dividend income.

  “The steady cash flows within REITS should provide defensive exposure against market downswings in the year ahead,” Morgan Stanley said.

  “Further, REITS offer built-in inflation protection through lease agreements, rent hikes and property appreciation that should allow the sector to weather the high inflationary environment relatively better than other sectors,” it added.

• Utilities: Valuations are already elevated, but Morgan Stanley is optimistic on this sector more for its downside protection, as opposed to any further upside.

  “With nearly all industries dealing with the effects of rising energy costs, the set pricing structure within Utilities should provide relative protection in this high cost environment,” it said.

A recession “requires extra patience” in deploying cash for any investment opportunities, said Wells Fargo Investment Institute.

Sameer Samana, senior global market strategist at the advisory firm, told CNBC that investors should “slow down” their pace of reinvestments because bear markets can last about a year, and sometimes cause drawdowns of around 30%.

“Long-term investors typically diversify for times like these,” added Scott Wren, senior global market strategist, also at Wells Fargo Investment Institute. “We recommend an incremental plan to deploy cash over the coming year (or longer) and continue to emphasize quality and defense in an effort to preserve capital.”

Short-term investors looking at a horizon of six to 18 months may benefit from holding additional cash and expect opportunities to enter the market in the coming months, said Wren.

Buy quality bonds, and steer clear of junk — or high-yield — bonds, the strategists said.

“We hold a preference for quality over junk as markets dive deeper into late cycle,” Morgan Stanley  strategists said. “We have seen sustained outperformance of quality versus junk since November 2021 when the shift to a more hawkish Fed occurred.”

In addition, the attractive income that bonds offer would offset the effects of widening spreads in a mild recession, according to American asset manager Nuveen. A yield spread is the difference in yields between government and corporate bonds of the same tenure. It recommends investment-grade corporate bonds.