Energy Stocks: A Surprising Defensive Play?

With volatility rising, many equity investors are thinking proactively about downside protection. But traditional safe havens may not do the job. Defensive equity positions can be found today in surprising places—like the energy sector.

After nine years of S&P 500 Index gains, investors are becoming increasingly nervous about the bull market’s durability. Rising interest rates, a return of inflation and geopolitical concerns have fueled volatility.

Rethinking Defensive Exposures

In the past, when investors sensed cracks in the market’s foundation, they flocked to more defensive sectors, like consumer staples. That sounds logical: if the economy is weakening, invest in companies with resilient businesses that sell what consumers can’t do without, such as household products, food, beverages and cigarettes.

But consumer habits are changing. Young consumers are focusing on healthier fresh foods. They’re not as brand loyal as their parents. Branded-goods companies are losing both leverage and pricing power with distributors. And of course, we can’t forget the 800-pound gorilla in the room: Amazon.

Investors should look beyond traditional safe havens, in our view. Companies with high-quality management teams, strong balance sheets and stable/growing dividends, supported by improving business trends, can often be found at better valuations in sectors that aren’t typically seen as defensive.

Rising Oil Prices Create a Positive Dynamic in Energy

The energy sector is a case in point. After years of challenges, energy companies look a lot more compelling. In recent months, oil prices have started to increase gradually driven by several factors, including geopolitical pressures, OPEC discipline, sanctions on Russia, renewed sanctions on Iran and higher oil extraction costs.

Let’s consider this scenario: A continued rise in oil prices could push inflation higher. In turn, the Federal Reserve might increase interest rates faster than expected to keep inflation in check. While this could slow the US economy, rising oil prices would support energy stocks. In this environment, we believe energy stocks could play a role as a nontraditional defensive position.