Should I invest in defensive companies or cyclical stocks during economic uncertainty?

It has been a volatile year, as the Iran war continues to have a widespread economic impact.

Amid this uncertainty, some investors may be considering putting money into defensive, instead of cyclical, stocks.

But what’s the difference? Here The Independent explores what you need to know about the two, their differences and key considerations for who should consider investing in them.

What are defensive and cyclical stocks?

Defensive stocks are those less likely to be impacted by economic conditions – as these companies offer essential goods and services, such as food, household goods, medicines, utilities, and broadband.

UK companies you can buy shares in as a defensive stock include grocery retailer Tesco, consumer products firm Unilever, pharmaceutical giant GSK and weapons manufacturer BAE Systems.

Cyclical stocks, on the other hand, are likely to be impacted by economic growth (or a lack thereof), and may benefit from discretionary spending. They operate in the banking, travel, leisure, manufacturing, housebuilding, infrastructure, automobile, and luxury goods sectors.

Examples of UK cyclical stocks include airline easyJet, fashion brand Burberry, home improvements firm Wickes and housebuilder Persimmon.

So far this year, the performance of cyclical stocks has surprised some experts after leading the European and US markets, despite the Iran war impacting the global energy market.

Jason Hollands, managing director at Bestinvest, says in the US, enthusiasm around AI and capital investment in infrastructure has driven market performance, while in Europe, banks and industrial firms have benefitted from resilient economic data and a wider economic boost from more defence spending.

Hollands also says investors appear to have “taken the view that the crisis will not be long lasting.”

What to consider before buying

If investors are worried about economic uncertainty, they may consider defensive stocks, as these companies are less likely to be affected.

Defensive stocks may be more suitable for conservative investors as they tend to have consistent demand, predictable earnings and cashflow.

“These stocks often pay consistent dividends, which can make them popular with those, for example, taking a pension,” says Derren Nathan, head of equity analysis at Hargreaves Lansdown.

Hollands adds: “They [defensive stocks] may not deliver the same level of gains as a cyclical during an economic boom, but they can help cushion portfolios in tougher times.”

Defensive stocks may also experience lower volatility than cyclical stocks, but could trade at a premium during any economic downturns.

On the other hand, cyclical stocks tend to be “more sensitive to changes in interest rates, inflation, and consumer spending,” according to Hollands. So, they may be less in demand during a recession, but have a stronger performance when the economy recovers.

Among the drawbacks to cyclical stocks is volatility, and potential fluctuations in dividend payouts, as changes to earnings expectations can have a big impact.

However, Nathan warns a defensive stock is not always a defensive investment, while a cyclical stock is not always risky.

“If an investor overpays for a stock offering more predictable earnings, that becomes a risky investment,” he adds.

“If the market is pricing a cyclical company as though the cycle will never recover, that’s potentially a low-risk opportunity.”

It’s worth stressing that defensive stocks can lower overall volatility, while cyclicals may offer growth.

The impact of your own outlook

It’s vital to consider the benefits and drawbacks before investing in defensive or cyclical stocks, but how do you choose?

This depends on “whether you are optimistic or pessimistic about the economic outlook,” says Hollands, who flags that some choose more defensive stocks due to “more predictable, resilient – and less volatile – earnings.”

Hollands says it’s sensible to own a blend of companies, which can be achieved via funds, rather than individual stocks.

“For example, funds like the IFSL Evenlode Income fund focuses on stocks with resilient, repeatable earnings and it does not invest in highly cyclical parts of the market,” he adds.

“Cyclical stocks are often prevalent in value funds that buy such companies when out of favour. For example, the Temple Bar Investment Trust has relatively high exposure to areas like banking and energy.”

Nathan agrees investors should hold both defensive and cyclical stocks for a diversified portfolio.

“Investors should take a long-term view, focusing on companies with good management, strong financial discipline and compelling customer propositions,” he adds.

“Those who think they have the superpower of predicting peaks and troughs in the cycle may dip in and out of cyclicals relatively regularly, but it’s well established that time in the market rather than timing the market is a more successful strategy.”

When investing, your capital is at risk and you may get back less than invested. Past performance doesn’t guarantee future results.