The Fed needs the economy to slow from here. These funds could outperform

Published Wed, Jul 26 20234:03 PM EDTUpdated Wed, Jul 26 20234:52 PM EDT

Jesse Pound @/in/jesse-pound @jesserpound

The Federal Reserve is not ready to declare victory over inflation just yet, and that means investors might want to approach the coming months like the final stretch of an economic cycle. The central bank hiked its benchmark interest by another 0.25 basis points on Wednesday, bringing its target range to the highest level in more than 20 years . And while Fed Chair Jerome Powell said that the central bank's staff does not predict a recession, he did say that the economy will need to further slow in order to defeat inflation. "Reducing inflation is likely to require a period of below-trend growth and some softening of labor market conditions," Powell said Wednesday. A slowdown could come even if the July hike is the final one of the cycle, as there is still the potential for delayed impacts from previous hikes tripping up the economy. "We have seen the impact, but not to the extent that the market expected or the Fed expected," said Venkat Balakrishnan, head of asset allocation at MissionSquare Retirement. "The Fed's worry is what they have done so far, is that enough? And they want to see more impact ... and the time is now to see it." The U.S. economy has been mostly resilient against the rate hikes so far, and the stock market rally has started to broaden out in recent weeks, reflecting growing confidence for investors. But deteriorating economic data could change that picture and spur investors to retreat into stocks and funds that are perceived to be less risky and tend to outperform at the end of an economic cycle. "With our economists calling for a mild recession in 2024 ... we might see a repeat of a short-lived recovery," Bank of America strategist Savita Subramanian said in a July 25 note to clients. "In the previous instances of short-lived recoveries, factor performance was generally consistent with a continuous downturn: Value lagged ... while High Quality, Low Risk and Large Caps outperformed." Andrew Smith, CIO at Delos Capital Advisors in Dallas, told CNBC that he is still expecting a recession and is splitting his portfolio between defensive plays and high-quality growth. He pointed to the iShares MSCI USA Quality Factor ETF (QUAL) and the JPMorgan U.S. Quality Factor ETF (JQUA) as funds that are capturing some of the market rally without adding outsized risk. Those funds have total returns of 23% and 18% year to date, respectively, according to FactSet. The holdings for both include some of the market's biggest tech stocks as well as Visa and Mastercard , which fit broadly within the factors that Bank of America identified. "Those are producing very decent returns, especially when you [compare them] to an equal weighted benchmark. You're getting a sense of okay, well, those are defensive equities. Those are growth-oriented defensive equities with strong balance sheets, high revenue growth, which is what investors seek during slow revenue or slow economic environments," Smith said. QUAL YTD mountain This quality factor ETF has risen more than 20% this year. Investors who are worried about a recession in the next few months could also look to buffer ETFs to lock in some of the year-to-date gains. Those funds have gained popularity over the past two years, creating a flood of new products such as a fund that provides 100% downside protection . "It does provide that element of risk management with the protection on the downside but also gives you participation on the upside up to the cap," said Charles Champagne, head of ETF strategy at AllianzIM, which is one of the asset managers that offers buffer products. If inflation continues to decline even without deterioration in the economy, early cycle stocks like small caps and value names could outperform as investors grow more confident in economic growth, according to the Bank of America note.