We’ve identified two issues that lead us to question whether this traditional approach may need some adjustment as we enter the later phases of the current business cycle.

In the first instance, we’re concerned about whether some traditional defensive sectors still merit their status. We explored some of the reasons in an article called ‘Today’s defensives may not be fit for tomorrow’ in the January 2019 edition of InvestmentInsights. For example, many companies selling consumer staples are under pressure from new-age brands that use social media to target audiences cheaply and effectively.

Healthcare and pharmaceutical companies usually enjoy relatively stable demand throughout the economic cycle but are facing increased scrutiny over drug prices in the US, where rising costs are a hot political issue. Meanwhile, in the UK utilities face a more punitive regulatory outlook and possible nationalisation if Jeremy Corbyn’s Labour Party comes to power.

What’s in a name?

As part of our ongoing research into what makes a sector or individual company cyclical, we’ve focused on equity sectors in the FTSE 350 Index. When economic activity is accelerating, cyclicals are supposed to outperform the market benchmark. But we have three questions. First, do we mean the global or domestic economy? Second, when we say outperform, do we mean prices or earnings? Third, over what period should we run our analysis? After all, businesses and sector compositions can change substantially over just a couple of decades.

In order to answer these questions, we’ve analysed share prices and their earnings performance relative to the wider stockmarket over various periods in response to changes in both global and UK economic indicators. The returns from different equity sectors tend to be most dispersed during the contraction phase of the cycle. Therefore, identifying the right characteristics at this time could potentially generate the best relative returns. The result is a list of sectors according to how they tend to perform throughout the cycle. (Figure 1 shows the sectors that are the most defensive according to our calculations.)

The choice between defining cyclicality in terms of economic sensitivity or market beta makes little difference to the composition of our list. Similarly, whether one looks at sensitivity to a global or UK economic indicator also makes little difference to a sector’s classification, with three exceptions. We’ve noticed that general retail, construction and materials, household goods and home construction have a strong cyclical relationship with the UK economy, even though they have an insignificant or even defensive relationship with the world economy. It may be worth bearing this in mind if the UK economy diverges from the global business cycle as a result of Brexit.

Measuring value

The second reason to be cautious about defensive sectors is that they look a bit expensive at the moment across various measures of value. One explanation is that equity investors have been unusually cautious over the past decade. Even though the global economy has been growing, the slow pace of the recovery since the financial crisis has dampened confidence.

But when defensive sectors are also expensive, this creates something of a dilemma. We believe it makes sense to be defensively positioned within equities, but are we really going to be better off if we’re buying expensive defensives?

In order to answer this question, we’ve explored whether today’s defensive sectors really are expensive. In deciding where to put money within UK equities, the relative valuation is important. Therefore, we’ve looked at the difference between the price—earnings (PE) ratio of each sector and the overall stock market. We’ve added the results to our defensiveness ranking (figure 1).

The third column of figure 1 shows the 25-year average of each sector’s relative PE. The fourth shows the average relative PE for the last three slowdowns (the early 1990s, early 2000s and the period leading up to the 2008 financial crisis). The fifth column provides a measure of today’s valuations compared with the past. It confirms that many defensive sectors are expensive, even compared with where they usually trade during a slowdown (which is when they are most appealing).

Are they worth it?

Are these defensive sectors too expensive to include in portfolios? To help answer this question, we’ve compared the initial (absolute) PE of the sectors just before the past three slowdowns with their subsequent returns relative to the market. We see no evidence to suggest higher valuations inhibit the performance of defensive sectors during a downturn.

In addition, when we differentiate cyclicals from defensives, we can see that cyclicals underperformed the market by around 11% on average even though they started with lower valuations. Meanwhile, defensive sectors outperformed by 11% despite more expensive starting valuations.

In the next stage of our analysis we put the initial valuations into a relative perspective by using valuation spreads — the amounts that sectors’ values differ from that of the total market. This does reveal a statistically significant relationship between a sector’s initial valuation and subsequent performance during a slowdown, especially when we isolate cyclical and defensive sectors.

Notably, the performance of cyclical sectors during periods when the economy is slowing are more susceptible to their initial valuation relative to that of the wider market. The higher a sector’s initial relative PE, the worse its relative performance during the following downturn.

Yet this relationship is weak among defensive sectors (particularly if we exclude mobile telecoms stocks during the dotcom bust). In most cases, regardless of the initial relative valuation, defensive sectors tend to outperform during a slowdown (figure 2).

There is a weak statistical relationship between the initial relative PE and subsequent performance, suggesting that defensive outperformance is even better when starting positions are cheaper. But this implies that valuations would have to be a whopping 15 times more expensive than the market before defensives would fail to outperform. None of our highlighted defensive sectors are anywhere near that expensive, suggesting they continue to earn their place in portfolios as the pace of economic growth begins to slow.