Where to Invest With the US Economy at Risk of ‘Overheating’: Citi
The US economy could be in tricky territory, Citi analysts are warning.
In a note to clients on Monday, the bank’s research arm said it believes the Iran war was pushing the macro environment from a “Goldilocks” state — an ideal scenario of robust growth and low inflation that helps fuel stock returns — to an “overheating” state. That’s an environment where growth is high, but inflation is running hot as well.
Though it’s more likely that the US will remain in a “Goldilocks” regime, signs are beginning to emerge that the economy is headed for the overheated zone, analysts said. The bank said there is a 62% probability that the global economy would transition into an overheated state within the next three months, citing “observed economic and market behavior,” such as the trend of investors rotating away from defensive stocks.
Inflation has also already started to creep higher since the war started. Consumer price growth accelerated to a 3.3% yearly pace in March, driven largely by hotter energy prices.
Concerns over inflation have swelled since the start of the Iran war, which has caused the price of oil, a major economic input that could influence inflation in other areas, to soar.
“With inflation risk elevated and the economic transmission of the energy shock still playing out, we examine what these binding constraints mean for factor performance,” analysts said. “Price and Earnings Momentum face downside risks, while upside is more conditional and skewed to a renewed supply shock,” they added of the outlook for the broader market.
The bank laid out a market playbook for investors navigating an overheated US economy, with various assets analysts believed would outperform in such an environment.
Here’s how investors should be positioned to avoid getting burned.
Quality stocks
Quality stocks, which are generally defined by companies with healthy financials and consistent earnings growth, are likely to outperform in the US and Europe, Citi said.
“Given the elevated level of uncertainty—around both the durability of any ceasefire and the future trajectory of inflation—Quality appears to offer the most attractive risk-adjusted positioning at this juncture,” the bank said.
The Invesco S&P 500 Quality ETF, one fund that tracks quality stocks, is up 6% year-to-date, outpacing the S&P 500’s 3% gain from the start of the year.
Value stocks
Value stocks, which trade at a lower price than implied by a company’s earnings and financials, are also a good bet.
“Our findings suggest that Value isn’t always a universe inflation hedge but works when growth expectations exist (Overheating),” analysts wrote. “Quality offers a potential ‘all-weather’ solution for the US.”
The Vanguard Value Index Fund ETF is up 5% year-to-date, also beating the market.
Cyclical stocks
Cyclical stocks, which tend to do well when the economy is growing, are expected to hold up across most “overheating” scenarios, barring a scenario in which economic growth is strong but “not exceptional,” Citi said.
The Vanguard Consumer Discretionary Index Fund ETF, one cyclical fund, is up 1% year-to-date.
If growth is weak, turn to defensives
Defensive stocks tend to see improving returns in an overheated economy when growth is at its lowest level, but inflation is hot, Citi said.
The Invesco Defensive Equity ETF is flat year-to-date, shedding less than 1%.
Be wary of growth stocks
Growth stocks tend to underperform in overheating scenarios that see elevated inflation, the analysts noted. In a scenario where economic growth and inflation are at their highest levels, the bank sees growth stocks declining by an average of 1%.
Growth stocks, particularly in the tech sector, have been hit hard amid concerns about AI and the broader risk-off move during the Iran war, but have rebounded sharply in recent weeks as hope for a ceasefire has grown. The Vanguard Growth Index Fund ETF is up 1% for the year.
