Monday?

Heard at the tables

nvestors are trying to play offense and defense simultaneously.

Money managers are shying away from risk, turning to defensive stocks and Treasurys in their hunt for safe places to invest their cash. Yet they appear equally worried about missing out on a potential stock-market rally. Institutional investors’ allocations to equities remain above the long-term trend, and their cash holdings aren’t out of line with historical averages, State Street data show.

Investors are betting that Wednesday’s quarter-point interest-rate increase from the Federal Reserve was its last—and that the central bank will pivot to cutting rates before the year is over. 

Are you feeling bullish about stocks? What market risks do you think might lie ahead in the coming months? Join the conversation below.

Although lower interest rates would likely be a boon for stocks, there is a growing conviction on Wall Street that a recession is looming. The panic in the regional banking sector threatens to take down additional banks and slow the economy as well.

“We’re going into a market environment without much precedent,” said Eric Crittenden, chief investment officer of Standpoint. “No one has a script or analog to rely on.”

A State Street indicator for asset managers’ risk appetite hasn’t registered a positive reading for the past three months, its longest stretch of caution since 2015. Positive readings signify investors are adding risk, whereas negative ones indicate they are pulling bacDespite their preference for conservative plays, investors don’t appear to be ready to give up on stocks. 

The S&P 500 is hanging on to a 7.7% gain this year, boosted by better-than-feared company earnings and resilient consumer spending. Meanwhile, the Cboe Volatility Index, also known as the VIX or Wall Street’s fear gauge, recently ebbed to its lowest level since 2021, a lull that has encouraged some investors to jump into the market.

In the coming days, investors will be looking to April’s inflation figures to gauge where the Fed might take policy. The consumer-price index is slated for Wednesday, with producer inflation on tap for Thursday.

Derivatives traders continue to wager that the Fed will cut rates by at least a half percentage point by December, even though Chair Jerome Powell has said interest rates will remain restrictive. Friday’s stronger-than-expected jobs report suggested the labor market has yet to crack, and government-bond yields rose in response.

Regional-bank stocks were on a roller coaster last week despite assurances from the Fed that the banking system is on solid footing. PacWest Bancorp, Western Alliance and other banks fell sharply before rebounding Friday.

One key factor that doesn’t bode well for stocks? They still look expensive historically, and valuations typically get crushed in a recession. 

Companies in the S&P 500 are trading at about 17.8 times their projected earnings over the next 12 months, according to FactSet, above the 10-year average of 17.3. Although economists generally agree that any recession this year will be short and shallow, the benchmark stock index has declined a median of 24% in recessions going back to 1946, according to research from Deutsche Bank. 

Ann Miletti, head of active equity at Allspring Global Investments, still says there are opportunities emerging in the market.

The weakness in regional bank stocks—and worries over the businesses they lend to—have led shares of smaller companies to underperform their larger peers since the collapse of Silicon Valley Bank. The Russell 2000 index of small-cap stocks is down 6.4% since March 8, while the S&P 500 has gained 3.6% over the same time frame. 

“Small-caps tend to outperform when inflation is falling,” she said. “I’m cautious in the near term, because I don’t think the banking fiasco is quite over; but I wouldn’t wait too long to go there.”

Ms. Miletti says she is just as focused on positioning for “what could go right” as what could go wrong for markets. Developments that seem off-the-table for now, such as peace talks in Ukraine or easing tensions between China and the U.S., could reinvigorate the stock market, she said.

To be sure, many analysts consider attempting to time such events a fool’s errand. Gearing portfolios for what might be ahead while staying in the market is a better option, they say. Companies with healthy balance sheets that can weather an economic slump are best positioned for the precarious path ahead, they add.

Some corporate management teams used the pandemic’s low-rate environment to borrow cash—often at variable rates—for acquisitions or share buybacks. But others issued cheap debt that won’t mature for several years, protecting them from rising debt costs. 

“A lot of companies need to prove their business model can survive a higher rate, higher inflation world,” said George Cipolloni, a portfolio manager at Penn Mutual Asset Management. “The math is just different now.”