This article is part of Morningstar's "Perspectives" series, written by third-party contributors. Here, Rob Morgan of Charles Stanley, explains when best to use defensive and cyclical investments.
A simplistic view of the stock market divides it into two components – “defensives” and “cyclicals”. Defensive companies are those providing goods or services whose demand is not influenced significantly by the state of the economy. Consumer staples, tobacco and utilities are examples of sectors broadly falling into this category. The fate of cyclicals, meanwhile, is strongly linked to the economy. If growth is strong demand for their products is high, but sales and profits can fall sharply in a downturn.
Clearly the picture is not as simple as this. Most companies have both defensive and cyclical attributes, and these can vary over time. However, the general rule is that cyclicals display more volatility as expectations of the economy change, while defensives are steadier, less likely to rise or fall rapidly.
However, today this textbook picture could be turned upside down due to the relative valuations we are currently seeing in the market. Many fund managers have been telling us defensive stocks are comparatively expensive compared to cyclicals, likely owing to the prevailing interest rate environment. With rates at all-time lows investors have been forced into higher risk asset classes such as equities to maintain the same level of income. Defensive equities with stable and rising dividends have become a target for yield-hungry investors who might not otherwise consider the stock market at all.
This trend also means defensives could be particularly vulnerable if the market falls due to a sudden rise in interest rates. If and when they do rise it will probably be because the economy is on a sounder footing, which actually bodes well for cyclicals. So we could see the unusual situation of traditional defensives underperforming in a falling market.
This scenario may or may not transpire. In an anaemic recovery where interest rates stay low for a very long time defensives could continue to outperform. Yet it is food for thought. When buying defensives investors should be aware of what they will and won’t defend against. While good at guarding against a stalling economy their solid characteristics may disappear when presented with rising interest rates. This was illustrated in the summer when markets fell as comments from Ben Bernanke, Chairman of the US Federal Reserve, on quantitative easing were interpreted as a sign interest rates might soon rise. Some of the more defensive areas took a significant hit before recovering as fears were assuaged.
It is therefore worth examining your portfolio and understanding the potential effects that different risks would have. Choosing to blend a variety of areas together seems sensible in order to diversify. Some fund managers, such as Stuart Rhodes of [
Silver rated] M&G Global Dividend fund, have chosen to introduce more cyclical holdings into their portfolio on the basis they represents better value overall – and could provide rising profits and dividend growth if economic recovery gathers pace.
