It wasn’t the interest rate decision made by the Fed recently but what Chairman Powell said after the meeting that shocked the markets. In fact, a subtle change in expectations may have foreshadowed the single best predictor for economic recession.

In fact, this recession indicator is seven-for-seven over nearly half a century.

Top it all off with market jitters over a trade war and other geopolitical problems and the bear could be coming sooner than you think.

The Real Danger Last Week Wasn’t The Rate Increase
The Federal Open Market Committee (FOMC) increased its target fed funds rate 0.25% as expected at its May 13 meeting, but it was the press conference that shocked the market.

#-ad_banner-#Policy makers shifted their expectations for further rate hikes higher, now expecting four quarter-point increases in 2018 and a benchmark rate as high as 3.25% next year.

That expectation for the benchmark rate is important because it’s higher than the group’s estimate for the long-term neutral rate of 2.87%, the interest rate that neither slows the economy nor provides any impetus. Essentially, the Federal Reserve is now saying that it is shifting from a policy of simply removing stimulus to actually working to slow the economy.

The move caused chaos in the yield curve, decreasing the yield difference between short-term and long-term Treasuries to the lowest point since 2007. The spread between two-year and 10-year treasuries fell to just 0.39% — meaning two more rate increases could cause the yield curve to invert.

An inverted yield curve is one of the best recession predictors with the spread falling below zero before each of the past seven downturns. In fact, St. Louis Fed President Bullard warned last month that, “you could be talking about [yield curve inversion] in September.”

The yield curve has inverted an average of 16 months before each of the last five recessions. While that still leaves the bulls more than a year, the market typically reacts ahead of the official start to a recession. The bear market correction started less than three months after the yield curve inverted in 1980 and 2000.

If that happens again this year, it could be time for investors to start positioning their portfolio for the change in the yield curve now.

Winners and Losers as Rates Continue to Rise
Even as the broader market is threatened by an eventual recession, a few sectors feel the pain earlier on the inverted yield curve.

Shares of financial companies could be hit on narrowing spreads as well as in the coming recession. Deposit-based banks may find short-term rates pushing up deposit rates faster than the rate they collect on long-term loans which would squeeze profits.

Regions Financial Corp (NYSE: RF) draws nearly two-thirds of its deposit base from consumers and in just six states. This leaves it exposed to regional risks as well as a weaker consumer if inflation and low wage growth continue. Shares have outperformed the sector with a 30% run over the last year and trade for 1.4-times book value, a 49% premium to the five-year average of 0.93-times. The bank was small enough to avoid many of the regulatory hurdles after the recession and may not benefit as much as peers in deregulation.

As is always the case when investor enthusiasm turns, the stocks that have risen the fastest may be the hardest to fall. Shares of tech stocks in the Technology Select Sector SPDR (NYSE: XLK) have jumped 127% over the last five years, followed by consumer discretionary stocks which have doubled over the same period.

That’s well beyond the 70.8% gain on the broader S&P 500 and could make for systemic problems when bulls turn to bears on these sectors. Tech stocks make up 28% of the S&P 500 by market capitalization. Steep drops in the sector will pull the rest of the index lower and further degrade investor sentiment.

Utilities and Telecom stocks could recover as a safety play both on their relatively stable revenue and high yields compared to bonds. Even as rates have increased, the return on bonds has remained extremely low compared to previous business cycles. That has drawn yield-hungry investors into the higher yield sectors for cash return.

Dominion Energy (NYSE: D) announced in March the first LNG shipment out of its Cove Point terminal in Maryland. The facility is only the second LNG export terminal to open in the continental United States and complements the company’s natural gas pipeline and storage assets.

The company started shifting in 2010 to assets outside of regulated utility and now operates a diversified mix of energy assets including pipelines and storage. The move gives the company greater growth while it still benefits from revenue stability on the utility portion of the business. The shares trade for 2.5-times book value and pay a solid 5.2% dividend yield.

T-Mobile US (NYSE: TMUS) capped four years of on-and-off talks with Sprint to announce a $26.5 billion merger earlier this year. Combining the third and fourth largest U.S. wireless carriers could help the company better compete against heavyweights Verizon and AT&T. The combined 600 MHz spectrum and Sprint’s 2.5 GHz spectrum would also position the company to lead in 5G application with immediate cost savings from the separate companies’ plans to building two networks.

Though the merger will reduce the number of players in the space, I see a good chance it will escape anti-trust concerns. The two largest carriers control 71% of industry service revenue so it could be argued that the tie-up will force more competition in wireless.

Risks To Consider: The yield curve may be a good predictor of recession, but stock sector performance will also be affected by other factors which could weigh on safety plays like Utilities and Telecom.

Action To Take: Keep an eye on the yield curve and position your portfolio in safety sectors while avoiding those that could take a hit when the curve inverts.

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