If you look at the U.S. equity markets this year, you’d probably think things are going pretty well.

Stocks were up 9-10% in the 1st quarter (although small-caps did comparatively worse). While there was a modest pullback in April, large-caps and tech stocks have recovered to the point where they’re in range of testing new all-time highs again.

In terms of macro conditions, things are fine now, but trending in the wrong direction. Inflation is moving higher. GDP growth disappointed in Q1. April’s jobs report came in weaker than expected and the unemployment rate ticked higher. Those three things are the foundation of the U.S. economy. If they start to go, everything else tends to follow.

But an annualized GDP growth rate of 1.6% and an unemployment rate under 4% don’t exactly scream catastrophe. Even if the numbers are moving in the wrong direction, the data doesn’t exactly signal an imminent collapse. Add in the potential of an interest rate easing cycle ahead and perhaps that’s what equity investors are considering here.

If that’s the case, why are utilities doing so well?

Since April 17th, a little over three weeks ago, the S&P 500 has gained 3%, while the Nasdaq 100 is up 2%. Utilities? They’ve gained more than 13%!

Utilities are traditionally considered one of the most defensive sectors of the market. Short-term swings back and forth between utilities and the S&P 500 are fairly common, but a 3-week stretch where utilities are outperforming the broader market by 10% and moving higher in a virtual straight line? That’s something else altogether.

Naturally, when you see something like this, you want to look elsewhere in the markets to see if other sectors or themes are confirming it. It’s not unheard of for a single sector to break off from its peers and stage its own rally. When that happens, there tends to be less underlying strength in the move and we usually see an eventual mean reversion.

If, however, we’re seeing similar behaviors from adjacent areas of the market, it could raise red flags.

For simplicity’s sake, let’s look at asset class returns over the past month, which is kind of when we began to see this turn happen. Here’s what we find.

• Over the past month (ending this past Friday), the S&P 500 is down 1.6% and the Nasdaq 100 is down 1.5%. This is our performance baseline.

• During that same time frame, only two S&P 500 sectors have generated positive returns - utilities (+5.1%) and consumer staples (+1.8%). Those are perhaps the two most defensive sectors in the equity markets, so we’re already seeing some defensive leadership.

• Looking at specific industries, one stands out - banks (+0.8%). Well, banks are interest rate sensitive and we’ve seen the 10-year Treasury yield drop by roughly 25 basis points from its late April peak, so that kind of lines up.

• On the fixed income side, the gainers have been high yield bonds (+0.7%), which is still a bit of a head scratcher to me, but there is still a lot of liquidity in the system and that could be propping this group up. Elsewhere, T-bills and floaters are positive, which is to be expected, so not much out of the ordinary here. I will note that while Treasury bonds are down on the month (-2.0%), they have rebounded strongly since interest rates peaked.

• Outside of that, there’s gold (+0.1%), which is essentially flat, but I’ll point out that it has been able to hold on to the 15% gains from that February-April rally and that says something about the strength in the precious metals market. The dollar (+1.2%) was also a gainer.

So let’s recap all of the asset classes that have posted positive returns over the past month while U.S. equities were declining - utilities, consumer staples, Treasury bills, gold, the dollar and (more recently) Treasury bonds. What do all of them have in common? They’re risk-off assets.

Even though the S&P 500 and Nasdaq 100 are climbing, I think we’re seeing a pretty notable shift to defense happening here.

I think how long this continues really depends on central banks, at least in the near-term. Over the past couple of years, stocks have rallied strongly at the perception of an imminent rate cutting cycle from the Fed. So far, investors have been head-faked at every turn and stocks retreated every time it happened.

Just look at this chart of the S&P 500 and see if you can figure out the points when investors talked themselves into impending rate cuts ahead and when Powell basically threw cold water on the idea.

As it stands, Powell has preached patience with regard to rate cuts. He’s explicitly said that progress on inflation has stagnated and with short-term annualized inflation rates running at around 4% right now, it’s difficult to make a case for rate cuts.

The market has priced in roughly 1.8 rate cuts before the end of the year with the first one more likely than not to come in September. I’ve already gone on the record saying that I don’t believe the first rate cut will come until December (the data won’t support it by September and the Fed will want to avoid changes during the election season to avoid the appearance of impropriety). If I’m right, stocks won’t get the catalyst they’re looking for until much further down the road.

To be fair, that doesn’t mean unlimited rally potential for defensive assets.

With rates elevated, long-term Treasuries probably don’t have a great deal of upside unless we get a larger flight to safety trade. Gold will have a tough time competing against 5% T-bill yields, although most of the recent buying has been done in Asia and by central banks, so there could be further upside there if that behavior were to continue. Defensive equity outperformance, including from utilities, consumer staples and healthcare, is the more likely outcome, in my opinion, over the next 6 months.

Final Thoughts

Part of the rally in utilities has been due to a defensive shift in the markets that’s being confirmed by other risk-off asset classes. Another part is being driven by the recent drop in interest rates (since utilities are very debt-heavy and interest rate-sensitive). The combination is fueling a rally in this sector that I believe is falling under the radar a bit.

If Powell comes out tomorrow and says, “yeah, we’re actually planning on cutting rates this summer”, all bets are off and utilities probably quickly become a laggard again. But I don’t think investors should be underestimating the signals here. The U.S. economy’s core macro data is all trending in the wrong direction and that could give legs to the current defensive shift.