Citigroup downgrades U.S. equities, says get defensive because of 'deflating bubble'

Published Fri, May 27 202211:01 AM EDT

It's time to get defensive on U.S. equities amid "significantly" rising recession risks, according to Citigroup. The global asset allocation team downgraded U.S. equities to neutral amid troubling signs — including disquieting signs in the stock market and hawkish guidance from the Federal Reserve chair — despite not technically holding a recession in its base case. "While typically equities only peak shortly before the start of a recession, this time it may happen earlier than we expected, potentially because we have elements of a deflating bubble," a Thursday note read. "We therefore cut our US equity allocation back to neutral, but stay long China and UK against Europe." The analysts issued their downgrade as stocks remain off their highs despite a bounce this week that could result in the first positive week in roughly two months. The S & P 500 briefly slipped into bear market territory last week. The Nasdaq Composite is about 26% off its 52-week high. Citigroup economists believe there is just a 30% likelihood of a recession, and just 10% probability of stagflation, meaning there's a 60% to 50% probability of a soft landing for the economy. Stock market to cause the recession? However, signs of a deflating bubble comparable to the one during the 2001 recession are troubling analysts. Stocks typically peak just before a recession, but the recent poor performance of the S & P 500 suggests that equities are underperforming much earlier than expected for a recession that is not likely at least in the next six months, analysts said. The declines in the broad market index suggests that stocks could be in a deflating bubble akin to the one before the 2001 recession, when stocks also declined much earlier than when the economic downturn actually occurred, analysts said. They noted that 40% of GDP has already disappeared, compared to just 30% during the 2001 bubble. "And, in the end, it was the deflating bubble that caused the recession," the note read. "While we would note that the potential wealth effect is cushioned by the fact that housing is still strong, and that the savings ratio never fell as much as it did during the 2000s (i.e. the wealth was not spent to the same extent), we would still see that as an ominous sign," analysts continued. Other signs also persist including hawkish guidance from Federal Reserve Chairman Jerome Powell, who highlighted his resolve in an appearance last week that he will not "hesitate" to back interest rate hikes to curb inflation. "At his most optimistic, he talked about a soft'ish' landing; at his more pessimistic, he spoke about possible pain in the labor market. It did not sound very comforting," the note read. "When the person in charge of preventing a recession expects a recession we listen." Analysts are also taking note of the brief inversion in the yields on the 2-year and 10-year Treasury notes. Investors take the inversion as a possible warning sign of a recession, though the signal does not necessarily predict when a downturn will occur. "In any case, our rates strategists do expect that we may reinvert sooner rather than later," the note read. Where to buy Still, there are some sectors in U.S. equities that offer a defensive tilt. Citigroup analysts are overweight healthcare and energy stocks that tend to outperform during recessions compared to financials and technology. Outside of the U.S., analysts said they prefer China equities because of expected fiscal stimulus measures that have so far been "somewhat disappointing. Still, analysts appreciate the country is "the only major market where authorities are at least marginally supportive." They also prefer UK equities compared to European equities, especially as the UK is less affected by rising oil prices than the Eurozone. Analysts also believe high recession risks in Europe are yet to be fully priced in.