Business Cycle

A client wants the portion of her equity portfolio least likely to see demand fall sharply during a contraction. Which industry best fits that description?

1. A.Manufacturing of luxury automobiles and other big-ticket discretionary goodsWrong. Large discretionary purchases are among the first that households postpone when incomes look uncertain.
2. B.Production of household food staples and non-alcoholic beveragesCorrect. People keep eating through downturns, which is why staples producers show comparatively stable demand.
3. C.Commercial construction and the manufacture of heavy machineryWrong. Capital spending on buildings and equipment is highly cyclical and is cut early in a contraction.
4. D.Business travel services and full-service hospitality operationsWrong. Travel budgets are discretionary for firms and households alike and shrink quickly when activity slows.

Why: Industries are classified by how sensitive their revenues are to the business cycle. Defensive industries sell what people buy in every phase, such as food, basic household goods, utilities and many pharmaceuticals, so their earnings hold up through a contraction. Cyclical industries depend on discretionary or capital spending and swing hard with the cycle. Note that defensive does not mean the stock cannot fall, only that demand for the product is comparatively stable.

A client holds a regulated electric utility because it is a defensive industry. Interest rates then rise sharply while the economy keeps growing, and she is surprised that her holding falls. What best explains it?

1. A.The defensive character of a utility applies only during periods of falling prices.Wrong. Defensive describes stable demand across the whole cycle, not behavior confined to deflationary stretches.
2. B.Regulated utilities lose customers as soon as borrowing costs in the economy increase.Wrong. People do not stop buying electricity because rates moved, and stable demand is exactly the point of the label.
3. C.The defensive classification describes the stock's price rather than demand for its product.Wrong. The classification is about demand for the product, and the surprise here is that the price fell regardless.
4. D.Utilities carry heavy debt and pay high dividends, which makes them rate-sensitive.Correct. Heavy borrowing lifts financing costs, and income-oriented shares must compete with bonds whose yields just rose.

Why: Defensive means demand for the product holds up through a contraction, and utilities qualify because households keep the lights on in any economy. That says nothing about interest rate exposure, and utilities are among the most rate-sensitive equities because they are capital intensive, heavily indebted and bought largely for their dividend yield. When bond yields rise, a utility's steady dividend looks less attractive by comparison while its financing costs climb. The defensive label would have helped in a recession; it offers nothing against this particular shock.