Business cycles and sector investing
In the first part of this three-part series looking at investing in sector ETFs, we discuss what business cycles mean and how you can invest to take advantage of the upturns or defend your portfolio during the downturns.
During different stages of the business cycle, certain industries tend to do better than others. Some investors will look to invest in sectors that they believe will outperform in the hope that this will be reflected in the share price of the companies that make up the sector.
The business cycle
Business cycles usually follow a similar pattern but are never identical. Sometimes certain phases in the cycle are skipped or even reversed. However, changes result from distinct shifts in indicators such as the growth rate of economic activity, employment and changes to monetary policy.
Early in the business cycle, as the economy starts to expand after a recession, credit conditions are loose as central banks keep interest rates low. This provides a platform for margin expansion and profit growth for companies. Sales start to increase as a result of improving consumer confidence, leading to economic growth turning positive.
As the economy continues to expand, credit growth will gain momentum and sales may continue to grow. Here the economy may approach its ‘peak’ and the central bank will start to increase interest rates to combat rising inflation.
Above trend inflation is a key indicator to an overheating economy. As the monetary policy screw continues to be tightened to cool economic activity, credit conditions are squeezed, which leads to a deterioration in corporate profit margins. Consumer confidence also declines leading to a fall in sales. The rate of economic growth will fall and the economy may even start to contract.
The earnings outlook for companies in certain sectors will improve at different points of this cycle.
The labels on the chart above point to sectors listed below that typically outperform relative to the wider stock market at different stages of the business cycle. These results are based on research by Fidelity which analysed the historical performance of each sector since 1962. The sectors below are based on the Global Industry Classification Standard (GICS) method of sector classification which we look at in more detail in the next article of this series.
- Financials, Consumer discretionary
- Information technology, Industrials
- Energy, Materials
- Consumer staples, Healthcare
- Utilities, Telecommunications services
Financials and the consumer discretionary sectors have historically outperformed the wider market during the early stages of the business cycle as cheap and readily available credit means borrowing amongst firms and consumers starts to pick up.
The outperformance then shifts towards companies that see a rise in demand for their products or services after a certain period of economic expansion. A sustained improvement in business confidence generally leads to a rally in information technology and industrials sectors as firms look to invest more and increase output.
Later, as the economy peaks and inflationary pressure mounts, the energy and materials sectors, have historically done well. Their fortune is closely tied to the prices of commodities, so when prices are high, so are their profits.
When the economy starts to contract, consumer staples and healthcare stocks have typically beaten the broader market due to being less economically sensitive than the aforementioned sectors.
Meanwhile, during a recession, defined as a period of two successive quarters of negative economic growth, utilities and telecommunication services companies have generally held up well due to high dividend yields providing a boost to total returns received by shareholders.
How to invest in sectors
We believe the best way to get exposure to individual sectors is by investing in exchange traded funds (ETFs). These look to track a specific basket of stocks that fit into a given sector of the economy.
A tax-efficient way to invest in ETFs is through a stocks and shares ISA. Commissions start at just £5 and there are no custody or platform fees.
There are hundreds of sector ETFs available so it is very important to understand which index the ETF is looking to track so that you know exactly what you are buying into. In a follow up article, we will explain the methodology behind how each index is created so that you can correctly gain access to the performance of the type of stocks you are looking for.