Investing in defensive or cyclical markets is a choice that must be carefully weighed: two indices can help to target the most performing and safe sectors. It is necessary for every investor to understand the difference between defensive and cyclical sectors, in order to invest with the best chance of profit and above all to reduce the investment risk to a minimum.
Investments in defensive sectors quickly gain momentum as uncertainty increases in the markets due to significant factors such as the Covid crisis, the China-US tariff war, Brexit, general prospects for an international economic recession. On the other hand, under conditions considered “normal”, investments in cyclical sectors are generally preferred.
What are the cyclical sectors
As the name suggests, cyclical markets are those where companies sensitive to the trend of the main macroeconomic data, such as GDP, industrial production, employment, are listed. In short, those companies whose activities – and therefore profits, coupons, dividends – accelerate when macroeconomic conditions improve or that slow down, to the limit of the crisis, if the economy worsens.
Examples of investments in cyclical sectors are those in the consumer discretionary market (consumer goods and cars among the main ones), financial, industrial, technology and materials.
What are the defensive sectors
On the contrary, for defensive investments we must mainly turn to markets where there are companies whose activities are less affected by general economic conditions, for example the market for basic necessities (food, drinks, household and personal products), energy, health, telecommunications. Obviously, investments in gold deserve a separate mention, the safe haven asset par excellence.
Important observation – Nothing is immutable, even the defensive sectors: under certain conditions (extreme, we could say) they too can enter into crisis, as it is also possible that new opportunities emerge from cyclical sectors during a crisis. The strength of renewal is immeasurable, especially during epochal crises such as the Covid pandemic. In articles such as Sectors and stock that will not recover after the coronavirus crisis and How markets will change due to the Covid crisis I propose some considerations and analyzes.
Defensive investments or in cyclical sectors: how to choose
The distinction between cyclical and defensive sectors is still a very general distinction between markets, but to understand where to invest you need further information and data to consider. In fact, it must be said first of all that investing in defensive markets, or those considered defensive “by tradition”, does not necessarily mean that the investment is defensive.
Furthermore, it is not certain that the behavior of cyclical sectors is regularly confirmed by the performance of the economy, as indeed that of defensive sectors does not necessarily.
Two indices can be useful to understand where it is safer and / or profitable to invest: the first is the Citigroup Economic Surprise Index Global, which analysts have also dubbed “economic surprise indicator” and measures the deviation of real macroeconomic data compared to the consensus of Bloomberg’s expectations.
Then there is the trend in the correspondence between cyclical and defensive stock prices worldwide, the sign of which represents how the two sectors are behaving: if the ratio is greater than 1 then the cyclicals are better, if lower than 1 are the defensives to record better performances.
If the Citigroup Economic Surprise Index Global is positive, with a good approximation we are in a market phase favorable to cyclical sectors, its drop below zero is almost always the sign of a more favorable period for the defensive sectors. But as the graph shows, especially for the three-year period 2017-19, there is not always full coincidence: here, therefore, is that for the choice between investing in defensive sectors or in cyclical sectors, one must not rely entirely on economic cycle indicators.
In fact, an investment in a defensive market, or considered as such, may not be “defensive” itself due to specific characteristics of the company or sector in which it operates or the specific moment. Therefore, an accurate and general analysis of the risks to which companies or sectors are exposed is required.