What Are Cyclical Stocks?
A cyclical stock is one whose performance is affected by that of the overall economy. What are examples of cyclical stocks? And which industries do they typically operate in? In this article, we will provide answers to these questions and many others.
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What Are Cyclical Stocks?
Cyclical stocks are the shares of companies whose prospects follow the stages of the economic cycle. But what is the economic cycle?
|Expansion: A period of economic growth|
|Peak: Slowing growth|
|Recession: Economic contraction, or decline|
|Recovery: The economy halts its decline and begins to recover|
Cyclical shares operate in industries which flourish during times of economic growth. The profits of cyclical stocks tend to rise in tandem with the economy and come under pressure during a contraction, with the company’s share price often taken along for the ride.
How to Identify Cyclical Stocks
Cyclical stocks tend to be shares in companies which produce consumer discretionary goods and services or, in other words, non-essential goods and services.
When the economy is growing, consumer spending on these goods tends to increase; on the other hand, when the economy begins to contract, these types of goods are usually the first to be trimmed from a budget.
Cyclical stocks can be contrasted with non-cyclical stocks which tend to perform consistently regardless of the health of the overall economy, which we will look at in more detail later.
Examples of Cyclical Industries
It is probably easiest to understand the meaning of cyclical stocks by looking at the sectors within which they tend to operate.
- Travel Stocks: Businesses which operate in the travel industry - such as airlines, cruise line operators and hotels – tend to perform better during times of economic expansion. Most people regard a holiday as somewhat of a luxury, so it stands to reason that during a recession, sales for companies operating in this industry will fall.
- Hospitality: When there is a downturn in the economy, people are less inclined to spend money going out to eat and drink, meaning that shares in restaurants, bars and other hospitality venues tend to suffer.
- Bank Stocks: Banks are cyclical businesses. During periods of economic growth, people spend more and, therefore, borrow more from banks to do so. On the other hand, when there is a recession, the opposite is true.
- Automobile Manufacturers: An automobile is a prime example of a purchase which is very likely to be delayed during an economic downturn, with consumers preferring to continue with their current vehicle.
- Technology Stocks: Again, as with automobiles, many new technology purchases – such as computers, mobile phones and games consoles – are likely to be forgone in times of economic hardship. However, it is important to note that not all technology stocks are cyclical.
- Mining Stocks: When the global economy is growing, people demand more of everything, meaning that more raw materials are required for production. In these circumstances, miners of metals such as copper and iron ore tend to perform well.
When it comes to cyclical shares, it is important to understand that not all economic downturns are exactly the same. Therefore, just because a stock is traditionally defined as cyclical, it may react differently to a recession depending on the exact circumstances.
A good and recent example of this is the economic downturn caused by the coronavirus pandemic in 2020. Whilst many traditionally cyclical stocks - such as banks - suffered, numerous others - such as Amazon - performed excellently, as consumers turned to e-commerce to ease lockdown boredom.
Examples of Cyclical Stocks
So, now we have an answer to the question ‘what are cyclical stocks’ and have some typical examples of cyclical industries – but what are some specific examples of cyclical stocks? Below are a few cyclical stock examples:
American Express earns money every time a customer uses one of their cards. So, when consumer spending increases, American Express earns more money, and when it decreases, they earn less.
Consumer spending tends to follow the stages of the economic cycle. When the economy is growing, people spend more money and, when it contracts, they spend less. Consequently, American Express is an example of a cyclical stock.
We mentioned above that the travel industry is cyclical, and so too are airlines. Simply put, demand for flights tends to increase during times of economic boom, and decrease when the economy is contracting.
Rio Tinto is the second largest mining company in the world by market capitalisation. It produces a number of commodities, but mainly iron ore, a key component in the manufacturing of steel.
Demand for steel tends to increase during periods of economic expansion, as construction tends to also increase. Consequently, Rio Tinto stand to generate more revenue from iron ore sales when the economy is growing than when it is contracting.
Non-Cyclical Stocks Examples
We already noted that cyclical shares can be contrasted with non-cyclical shares – which tend to perform fairly consistently regardless the prevailing economic climate. Such stocks can be referred to as non-cyclical, however, are more commonly known as defensive stocks.
Non-cyclical stocks typically produce goods and services which are considered consumer staples or, in other words, essential. These non-cyclical stocks operate in so-called defensive industries, such as utilities and healthcare, and are often considered to be fairly recession resistant.
Below are some typical examples of non-cyclical stocks.
The beverage giant’s powerful brand and wide range of products mean it can rely on a fairly consistent level of demand throughout the economic cycle.
Unilever is a consumer staple company which owns a number of strong brands, including Hellmann’s, Dove, Ben & Jerry’s and Vaseline. Like Coca-Cola, these strong brands make Unilever an example of a non-cyclical stock.
UK-based alcohol stock Diageo, produces and sells a wide variety of alcoholic beverages, including some of the world’s most popular brands. Whilst alcohol is certainly not an essential good, consumers tend to demand it regardless of what is going on in the wider economy.
What Are the Best Cyclical Stocks for 2023?
So, are there any examples of cyclical stocks which could be poised for a successful year in 2023?
The economic outlook has certainly improved in 2023, although we should be careful about overestimating growth, which is likely to remain suppressed. Whilst inflation is falling in many economies, interest rates are likely to remain elevated for the remainder of the year, dampening consumer demand and keeping debt servicing costs high for businesses.
There are a few industries which stand to potentially benefit from rising interest rates, one of which is banking. In the UK, interest rates have risen from 0.1% in December 2021 to 5% as of June 2023, as the Bank of England (BoE) has attempted to curb high inflation.
As a result of this tightening of monetary policy, UK banks have predictably seen an increase in net interest income from lending operations. However, other banking divisions, such as investment banking, have struggled somewhat.
The lack of an investment banking division and its leading position in the UK mortgage market, means that Lloyds Banking Group is uniquely positioned to potentially benefit from a climate of higher interest rates.
Nevertheless, higher interest rates also pose a risk to Lloyds in the form of a potential increase in loan defaults, something which Lloyds and other banks need to guard themselves against by setting aside money to cover bad loans.
As inflation cools, interest rates are likely to come back down, although are unlikely to drop as low as they were between 2009 – 2021 in the near future. This would result in higher net interest income than banks have been able to generate for much of the last decade, and less provisions against bad debt than is necessary in the present moment.
Now that you understand the meaning of cyclical stocks and have some examples, you may be wondering why anyone would add stocks to their portfolio that are likely fall in value if there is an economic downturn. Why not focus solely on non-cyclical, defensive stocks?
Perhaps there are some more risk conscious investors that do opt for this approach, picking investments which solely operate in defensive industries, and which are not prone to fluctuate along with the whims of the overall market.
However, many successful portfolios are often made up of both cyclical shares and non-cyclical shares. Portfolio diversification is an important aspect of investing and, whilst investors may want to treat cyclical shares with increased caution, it may be wrong to avoid them altogether.
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