US inflation has been much higher than economists expected, and now more investors are worried that the country’s central bank will overreact, hiking interest rates so much that it tips the economy into a dreaded recession. So investment bank Goldman Sachs has taken a look at what that might mean for US stocks.

How bad does the situation look?

Investors had hoped that US inflation had turned a corner and would start easing this summer, and it still might, but it only got hotter in June. As a result, a growing number of them are now betting that the US Federal Reserve (the Fed) will hike interest rates by an entire percentage point next week in order to combat inflation.

The US economy shrank by an annualized 1.6% in the first quarter of the year and although current forecasts suggest it won’t have shrunk again in the second quarter – avoiding for now a “technical recession” – investors’ worry is that higher interest rates are going to drag down borrowing and spending, and push the economy into a recession eventually anyway. In other words, a recession seems all but inevitable.

What’ll that mean for US companies?

Based on Goldman’s scenario analysis, S&P 500 company profits as measured by earnings per share (EPS) would fall 11% in 2023 compared to 2022’s level if the US economy shrinks modestly next year – i.e. if there’s a moderate recession. The bank sees a 30% chance of a US recession within the next year and a 50% chance of one within the next two years. Arguably, though, the Fed’s set to nudge those probabilities higher.

For context, in the eight US recessions since 1970, S&P 500 company earnings have fallen by an average of 14%, so an 11% drop in earnings would be consistent with a modest shrinking of the economy. Goldman is estimating that revenues of S&P 500 companies would actually hold pretty stable in a recession, but that the squeeze on profit margins would be responsible for the EPS decline.

Looking at individual industries, cyclical sectors – those that see demand for products and services rise and fall with economic growth – typically experience the biggest profit drops in a recession. So that means consumer discretionary, industrials, and materials firms are likely to get sandbagged. On the flip side, most of the so-called defensive sectors will probably justify their moniker: the utilities, healthcare, and consumer staples industries have typically grown their earnings during recessions. This time around, some consumer staples firms won’t be so lucky: sky-high inflation’s hitting their costs, meaning profit margins and therefore earnings are likely to fall.

What’ll that mean for US stocks?

In Goldman’s recession scenario, the S&P 500 would fall to 3,150 by the end of 2022 – a roughly 17% drop from its current level. If the bank is right, it’d mean a “peak-to-trough” price decline of 34%. That’s worse than the historical average recession decline of 30%, but in line with the average bear market decline since the Second World War. For context, Goldman’s current S&P 500 forecast for the end of the year is 4,300, or about 14% higher than current levels.

What’s the opportunity here?

What’s clear is that in a recession, defensive sectors generally tend to perform best. And if more and more investors think there’s one coming, then it might as well be here already where the stock market is concerned. So, you may want to tilt your US stock holdings toward the utilities, healthcare, and consumer staples industries. There are countless exchange-traded funds (ETFs) to consider as you do this, but these low-cost ones (expense ratio: 0.1%) may be a worthwhile place to start: the Vanguard Utilities ETF (VPU), Vanguard Health Care ETF (VHT), and Vanguard Consumer Staples ETF (VDC).

Of course, the relative outperformance these industries may offer mightn’t leave you feeling great since they could potentially fall in absolute terms. One way to try and eke out an absolute profit is to both buy the shares or ETFs of defensive firms or sectors and short the S&P 500. That way, you’ll profit from the difference in performance between the two. Shorting is always risky, mind you: your potential losses are theoretically infinite.